Capital Gains Exclusion for Sale of Primary Residence

I think everyone is somewhat familiar with the idea that when they sell their primary residence (stock in a co-operative housing corporation (co-op) can also receive an exclusion if you meet the tests) they do not have to pay all the capital gains, so like my other posts, I wanted to explain (in English) what and how you may exclude a portion of your primary residence’s increase in value upon a sale.

In 1997 Uncle Sam enacted Internal Revenue Code Section 121, found here, and better outlined here. VERY Simply put, a single person can exclude $250,000 of gain on his or her primary residence ($500,000 if married).

First and foremost, this exclusion applies to profits not sale price.  Also, anything above the exclusion amounts will be taxed at long term capital gains rates (they must be long term because of the below requirements).  Like most tax exclusions there are some requirements, but these are not huge hurdles.

Capital Gains Exclusions for Sale of Primary Residence

There are two basic tests:

  1. The use test
  2. The ownership test

The use test – In the past 5 years you Lived in the home as your main home for at least 2 years.  It should be noted that the use test portion does not have to be continuous.

The ownership test – In the past 5 years you owned the home for at least 2 years

At the link above, the IRS even gives tons of examples, here is just one:

Susan bought and moved into a house in July 2003. She lived there for 13 months and then moved in with a friend. She moved back into her own house in 2006 and lived there for 12 months until she sold it in July 2007. Susan meets the ownership and use tests because, during the 5-year period ending on the date of sale, she owned the house for 4 years and lived in it for a total of 25 (13 + 12) months.

There is an additional requirement that you can not exclude the gain if you have excluded gain on another sale of a principal residence within the prior two years.

Joint Returns

You can exclude up to $500,000 of the gain on the sale of your main home if all of the following are true.

  • You are married and file a joint return for the year.
  • Either you or your spouse meets the ownership test.
  • Both you and your spouse meet the use test.
  • During the 2-year period ending on the date of the sale, neither you nor your spouse excluded gain from the sale of another home.

Spouse Dies and the Capital Gains on Home

I am not fully familiar with the Mortgage Forgiveness Debt Relief Act of 2007 but I do know that it did help out a widow or widower when they sell their primary residence when their deceased spouse passed away.  After Jan 1, 2008 the widow or widower has 2 years to sell the home to receive the $500,000 exclusion (assuming he or she didn’t remarry).  Along with this $500,000 exclusion he or she would have the step up (a future post) on the 1/2 portion from the deceased spouse.  These two tools are powerful tools for a  wealth transfer, especially useful during a hard, emotional time.
As I have mentioned I am from New York and do not deal with the midwest all that much, as such, there are additional Community Property issues, not covered here.  As always nothing here should be construed as legal, financial or tax advice.

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