Understanding the Home Sale Tax Exclusion

This article was published in the August 2023 issue of the Traverse City Business News and can be read in its entirety below. Black Walnut Wealth Management contributes articles and is featured in various media outlets.

The home sale process is filled with uncertainties, such as how long it will take to sell and if you will get your asking price. But there's one question that doesn't have to remain a mystery: whether you will owe taxes on the sale of your home.

The answer depends on your eligibility for the home sale tax exclusion. Here's what you need to know about this valuable tax break.

What is the home sale tax exclusion?

The home sale tax exclusion helps homeowners save on taxes by allowing them to exclude a certain amount of profit from capital gains taxes when they sell their home.

Under the current law, individuals can exclude up to $250,000 of capital gains from the sale of their primary residence, provided certain conditions are met. Couples filing a joint tax return can exclude up to $500,000 of capital gains. Widowed homeowners may also qualify for the $500,000 exclusion amount if they sell their house within two years of their spouse's death and fulfill the other eligibility requirements.

How to qualify for the home sale tax exclusion

There are two main ways to determine your eligibility for the home sale tax exclusion: the ownership test and the use test. Here's a breakdown of each:

Ownership test

You need to be the legal owner of a property to qualify for the home sale tax exclusion. To pass the ownership test, you must have owned your home for two of the last five years before the sale date.

This offers flexibility to homeowners that rent out their homes. For example, if a person lived in their house for a year, moved somewhere else, rented the home for another year, and moved back for a final year before selling, they would still qualify for the exclusion.

You may need some or all of the following documents to prove home ownership.

Proof of ownership documents:

Deed
Mortgage statements
Property tax bill
Homeowners insurance contract

Use test

The home sale tax exclusion is only available for the sale of a primary residence. The IRS considers a primary residence to be a home you have lived in for at least two of the previous five years before selling the home. The two years don't have to be successive, but you must show that you lived in the house for a total of 24 months, or 730 days, in the past five years.

If you don't pass the use test, you may still qualify for the home sale tax exclusion in certain situations. For example, if you're selling your home due to a change in employment, health or other unforeseen circumstances, you may still be eligible for a partial exclusion.

If you meet the ownership and use requirements, you can take the home sale tax exclusion as many times as you want, but not more than once every two years.

How the home sale tax exclusion works in real life

Let's say you purchase a home for $700,000 that is now worth $800,000. If you sell the home for that amount, it’s considered a $100,000 profit ($800,000 - $700,000.) Individuals can exclude up to $250,000 of profit from a home sale, which means you won't owe any capital gains taxes. If you don't qualify for the home sale tax exclusion, you would be responsible for paying capital gains taxes on the entire $100,000.

However, if you purchase a home for $700,000 and sell it for $1,000,000, that is a $300,000 profit. Any gain above the exclusion amount—in this case, $50,000 ($300,000 - $250,000) is subject to capital gains tax. If you’re married and file a joint tax return with your spouse, you wouldn't owe any taxes since the exclusion amount for couples is $500,000.

Current capital gains tax rates.

What happens if you don't qualify?

Not all homeowners qualify for the home sale tax exclusion. You may not be eligible for the tax break if:

You haven’t owned and used the property as your primary residence for at least two of the previous five years
You have already used the home sale tax exclusion within the past two years
You acquired your home through a 1031 exchange within five years

Even if you don’t qualify, there are other ways to reduce the taxes from selling your home. Tallying up the costs of home improvement projects is one way to reduce your taxable gain.

Deductible home improvements include:

Bedroom or bathroom additions
Replacing walls and floors
Updating heating and cooling systems
Any other major projects that add value to your home

Final thoughts

Understanding the home sale tax exclusion can help alleviate some of the uncertainty around selling your home. It's important to note that many factors can impact your eligibility for the home sale tax exclusion, and you should consult a tax professional for advice on your specific situation.

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