Refresher on the Home-Sale Gain Exclusion Tax Break

In many areas, residential real estate markets have surged, and some are still surging. In these sellers' markets, big home-sale gains are likely. That's great news if you're a seller—but will you owe taxes on the profit?

If you sell your principal residence for a large profit, you can potentially exclude tax (pay no federal income tax) on a certain amount of profit. Here are the basics of how to take advantage of this tax-saving opportunity.

Gain Exclusion Qualification Rules

Single taxpayers can exclude home-sale gains up to $250,000, and married joint-filing couples can exclude up to $500,000. However, you must pass the following tests to be eligible:

1. Ownership test. You must have owned the property for at least two years during the five-year period ending on the sale date. Two years means periods aggregating 24 months or 730 days.  
2. Use test. You must have used the property as your principal residence for at least two years during the same five-year period. (See "What Counts as a Principal Residence?" below.) 

Periods of ownership and use don't need to overlap. For example, you could rent a home and use it as your principal residence for Years 1 and 2, and then buy it and rent it out to others for Years 3 and 4. If you then sell the property in Year 5, you'd pass both the ownership and use tests and qualify for the gain exclusion privilege.

Important: To qualify for the larger $500,000 joint-filer exclusion, at least one spouse must pass the ownership test and both spouses must pass the use test.

Anti-Recycling Rule

There's another qualification rule for the home-sale gain exclusion privilege: It's generally available only if you haven't excluded a gain from any earlier sale occurring within the two-year period ending on the date of the later sale. In other words, the gain exclusion privilege generally can't be "recycled" until two years have passed since you used it last. For married couples, the larger $500,000 joint-filer exclusion is only available when neither spouse excluded a gain from an earlier sale within the two-year period.

For example, suppose you sold your previous principal residence on July 1, 2020, and excluded the gain. Before selling that home, you purchased another property and began using it as your new principal residence on January 1, 2020 (six months earlier). You plan to sell the second principal residence for a big profit in March 2022, mistakenly assuming you'll qualify for the gain exclusion break on that sale, too.

Why is that assumption wrong? While you'd pass the ownership and use tests, the March 2022 sale date would run afoul of the anti-recycling rule, because it's within two years of the July 2020 sale. Therefore, you'd be ineligible to exclude any gain from the 2022 sale. However, if you can wait until July 2022 to sell your current principal residence, you can claim the gain exclusion break for that sale.

Alternatively, if you can't wait that long to sell your current principal residence and the profit from that sale is bigger than the profit from the 2020 sale, you can amend your 2020 tax return. On the amended 2020 return, you could forego the gain exclusion break and, instead, report the profit from the 2020 sale as a taxable gain. Then you can claim the gain exclusion break for the more-profitable 2022 sale.

Net Investment Income Tax

Does the 3.8% net investment income tax (NIIT) apply to home sales? If you sell your main home, and you qualify to exclude up to $250,000/$500,000 of gain, the excluded gain isn't subject to the NIIT.

However, gain that exceeds the exclusion limit is subject to the tax if your income is over a certain amount. The NIIT applies only if your modified adjusted gross income (MAGI) exceeds:

• $250,000 for married taxpayers filing jointly and surviving spouses,
• $125,000 for married taxpayers filing separately, and
• $200,000 for unmarried taxpayers and heads of household.

Gain from the sale of a vacation home or other second residence, which doesn't qualify for the exclusion, is also subject to the NIIT.

What Counts as a Principal Residence?

This can be a good question if you own and occupy several residences. The general rule says your principal residence for the year is the one where you spend the majority of time during that year. According to IRS regulations, other relevant factors can include:

• Where you work,
• The mailing address used for your bills and correspondence,
• The address shown on your income tax returns, driver's license, and auto and voter registration cards,
• Where you maintain your bank accounts,
• Where you maintain religious affiliations and club memberships, and
• Where family members and pets live.

For example, Maria owns one home in Texas and another in Florida. From 2017 to 2021 (five years), she spends seven months each year in the Texas home and the remaining five months in the Florida home.

Maria sells both properties in January 2022. Barring unusual circumstances, the Texas home is considered her principal residence, and she can claim the gain exclusion privilege only for that property. That's the case even though she spent about 25 months in the Florida home during the five-year period ending on the sale date (more than the requisite 24 months).

Can you pass the ownership and use tests for two residences at the same time? This is possible in certain situations. For example, Barry owns one home in Ohio and another in Nevada. During 2018 and 2019, he lived in the Ohio home. During 2020 and 2021, he lives in the Nevada home.

If Barry sells either home in 2022, he'd qualify for the gain exclusion privilege because he passes the ownership and use tests for both homes. However, if he sells both homes in 2022, he can't claim gain exclusions for both sales. That's prohibited by the anti-recycling rule explained in the main article.

Contact a Pro

For many homeowners these days, the federal home-sale gain exclusion deal is one of the most valuable personal income tax breaks on the books. But there are numerous rules and restrictions. Your SSB tax professional can help you cash in. As with any major financial transaction, you should consider the federal income tax consequences before closing on a home sale.