One of the biggest tax breaks in the tax code is the home sale exclusion. If you qualify, you can exclude the tax on the first $250,000 of gain from the sale of your principal residence, doubled to $500,000 if you file a joint return. But the exclusion is not available if you do not meet certain requirements.
Saving grace: Even if you fall short, you may be eligible for a partial tax exclusion permitted for a handful of exceptions. It is critical to carefully observe the rules in this area.
To qualify for the home sale tax exclusion, you must have owned and used the home as your principal residence for at least two out of the previous five years. Generally, you cannot claim an exclusion if you do not meet the ownership and use tests or if you claimed the exclusion within the last two years.
However, if you sell the home without meeting the two-year requirement or if you have claimed the exclusion within the last two years, you still may be eligible for a partial exclusion. This tax break is allowed only if you sell the home due to a change in employment, a need for medical care or other unforeseen circumstances.
For this purpose, the IRS has issued regulations defining “unforeseen circumstances.” The list includes the following occurrences:
• loss of employment
• an employment change that reduces your ability to pay for the home
• multiple births from a single pregnancy
• damage from a disaster
• taking of property
If none of these exceptions apply, the IRS will examine the facts and circumstances of the case. The most important factors are whether the home has become less suitable as a principal residence, if your ability to pay for the home has materially decreased and if the rationale for the sale could not have been reasonably anticipated when you acquired the home.
How much is the partial exclusion? It is equal to the available exclusion amount (a maximum of $250,000 or $500,000, depending on your filing status) multiplied by the percentage of the two-year limit for which you qualified.
Example: Suppose that you are a joint filer and you and your spouse have owned and used a home as your principal residence for nine months. Due to unforeseen circumstances, you are forced to move, so you sell the home at a $200,000 gain. Unfortunately, you do not qualify for the full home exclusion because you have not met the two-year requirement.
Nevertheless, you can still salvage a partial exclusion. The appropriate percentage is 37.5% (nine months divided by 24 months). When you multiply $500,000 by 37.5%, the result is $187,500. Thus, you can exclude $187,500 of gain from tax, and the remaining $12,500 is taxable as a capital gain.
Under the capital gain rules, a capital asset held for a year or less is taxed at ordinary income rates. Any long-term gain is taxed at a maximum 15% rate, or 20% if you are in the top ordinary income tax bracket. Consult your professional tax adviser for your situation.