As a result of my practice areas covering tax related matters and real estate transactions, clients often ask me whether they will be in for a surprise when they file their tax return the year after they sell their home. As with most legal questions, the answer is “it depends.” I have found that most people automatically assume they will pay no income tax from the gain that may result from the sale of their home. However, that is not necessarily true. Here’s why.
The Internal Revenue Code (“Code”) provides the following with respect to excluding the gain from the sale of your principal residence:
Gross income shall not include gain from the sale or exchange of property if, during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating 2 years or more.[1]
Here are the key components to this part of the Code section: (a) an understanding of what principal residence means; (b) the five-year period ending on the sale of the home; and (c) the amount of time you lived in the home during the five-year period.
The determination of “principal residence” is based on a facts and circumstances analysis that considers, for example, where you spend most of your time, your primary mailing address and the proximity of the home to your work location.[2]
If you considered the home you’re selling your principal residence for a total of two out of the last five years prior to the date of sale, then you meet what I call the “time” test.
Now, here’s the second part, which is what I call the “dollar amount” component. For single tax filers, the amount of gain that you’re allowed to exclude is $250,000.[3] For married filing jointly filers, the amount of gain doubles to $500,000.[4] In the event that you meet the “time” test, any gain above your applicable exclusion threshold needs to be reported as income on your tax return.
There are exceptions to this rule, such as for work-related moves, unforeseeable circumstances and health-related moves.[5] Some of these exceptions may allow for a total or partial exclusion of gain from the sale of your primary residence depending on other facts and circumstances.
In any event, above-mentioned factors should be evaluated when preparing your tax return the year following the sale of your primary residence.
[1] I.R.C. § 121(a).
[2] See IRS Pub. 523, Sale of Your Home, located at http://www.irs.gov/publications/p523/ar02.html#en_US_2014_publink10009003
[3] Id. at (b)(1).
[4] Id. at (b)(2).
[5] See IRS Pub. 523, Sale of Your Home, located at http://www.irs.gov/publications/p523/ar02.html#en_US_2014_publink10009003
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