Understanding the Home Sale Tax Exclusion

You've thought long and hard about it and have decided: It's time. You're going to sell your house. And while this is an exciting time, it also comes with a whole host of questions. Should I use an agent? How much should I list it for? What do I do with the cash after the sale?

All of these are important. But one thing you cannot ignore is this: Do you have to pay capital gains tax on the proceeds of your home sale?

The answer is that you do unless you have the Home Sale Tax Exclusion.

This important exclusion helps most homeowners avoid the burden of a heavy tax on the sale of their homes during a move. Let's review the requirements and see how a person qualifies for the Home Sale Tax Exclusion.

Qualification for the Exclusion

To qualify for this huge tax break, homeowners must do a couple of things. First, they must own the home. This may seem like a silly distinction, but the seller must have legal ownership of the property without any sort of strange situation that could interfere with that person’s ability to sell. Second, they must have used the home for two years as their primary residence. However, the two-year period is the minimum time that the homeowner must have lived at the property in five years, giving flexibility to those who have moved away temporarily.¹

Two years is the total time, but it need not be contiguous. This allows home rentals. If a person lived in a home for a year, moved somewhere else, rented the home for another year, and moved back for the final year of that person’s ownership before selling, he or she may still qualify. 

Another key component of this exclusion is total profit. Profit being sale price - (purchase price + improvements (but not repairs)). The exclusion can only be applied up to $250,000 for a single individual. This can be extended to $500,000 for married couples that file their taxes jointly. Note: these amounts are profit, not total value. An individual can sell a home for $950,000 and still qualify if he or she originally paid $500,000 for the house and made $200,000 worth of allowable improvements to increase the tax-basis.⁴

Last, this exclusion is only available every two years. This means if you sell a home, move to a new house, then decide after a year that you don't like it and sell it immediately, you are unlikely to qualify for this exclusion.

Not Qualifying for the Exclusion

If one of the rules for this exclusion isn't met, the seller does not qualify for this tax break. He or she will be required to pay a capital gains tax on the profit of the sale of the property. But how much?

This depends on holding period and your income bracket. 

Assuming you own the home for more than one year, long-term capital gains are based on income, with most Americans paying a maximum of 15%. Individuals making over $492,300 and couples (married-filing-jointly) who make more than $553,840 will pay higher amounts. Even at 15%, this tax can take a big chunk of people’s profit from their home sale. Making decisions based on the ownership and use rules of the exclusion can potentially save thousands in taxes when it is time to sign contracts and transfer ownership.²

A Valuable Perk for Homeowners

This exclusion helps most homeowners avoid paying higher taxes on selling their only home and moving to a new one. If you’re considering selling your home and aren't sure if you might have to pay, reviewing the requirements to see if you qualify can take a big weight off your shoulders.