Normally, when a taxpayer sells an asset for more than they paid to acquire it, there is a gain recognized, and the gain is taxable. However, in the case of individuals who sell their “main home” at a gain, IRC Section 121 allows for gains up to certain amounts to be excluded from the taxpayer’s income.1 The purpose of this article is to describe the basics behind excluding amounts of gain on the sale of a taxpayer’s main home.
Qualifying for the Exclusion
The basic rules for taxpayers qualifying to exclude gains on the sale of their home are as follows: first, the residence sold by the taxpayer must have been the taxpayer’s primary residence.2 The more obvious aspect of this rule is that the residence must have been the primary residence of the taxpayer. Excluding gains from the sale of the taxpayer’s secondary home is not allowed. The second element is that, under Section 121, the taxpayer may only exclude gains from the sale of a residence–however, the term “residence” is defined somewhat loosely. Under the Regulations, a residence here can mean not just a home or condominium, but also a “houseboat” or “house trailer”.3 The rules here are similar enough that you can likely assume that the rules for what constitutes a residence in relation to deducting mortgage interest also apply here.
The second rule relates to how long the taxpayer used the home sold as their primary residence. During the five year period before the date when the taxpayer sells their home, the taxpayer must have both owned and used the residence as their “principal residence”.4 The 5-year rule for qualifying for the gain exclusion is especially helpful to taxpayers who move out of their residence (due to relocating for a new job, for example) and are not able to sell their old residence for a couple of years.
The third general rule is that the taxpayer cannot have already excluded gains on the sale of their principal residence anytime within the last two years before the date of the sale of the residence.5 This of course presents an important tax planning opportunity for taxpayers in relation to the timing of a sale of their home.
Amount of Gain Exclusion
As nice as the exclusion is to take advantage of, there are caps on the amounts of gain that can be excluded by taxpayers each time they make use of the exclusion. The rules for the exclusion amounts, however, are quite simple: for single return filers, the maximum exclusion amount is $250,000. For joint filers, the maximum exclusion amount is $500,000.6 Any gains exceeding the applicable maximum exclusion amount may not be excluded and, rather, are considered amounts of taxable income.
There is one additional allowance for taxpayers who are surviving spouses that may qualify the taxpayer for the full $500,000 maximum exclusion. So long as the surviving spouse qualified for the full exclusion on the date when the decedent spouse passed away and the surviving spouse sells the home within two years after the date of the decedent spouse’s death, the surviving spouse may exclude $500,000 of gain.7
How are Exclusions and/or Taxable Gains Reported?
Assuming the taxpayer qualifies for an exclusion amount sufficient that all of the taxpayer’s gain on the sale of a home is excluded, the taxpayer does not report the gain at all on their tax return. Effectively, the taxpayer files a tax return as if the sale of the home never really happened.
On the other hand, in situations where the taxpayer does not qualify for the gain exclusion (or in cases where the amount of gain exceeds the maximum exclusion), the gains must be reported as income on the taxpayer’s return. In most cases, the full gain, as well as the applicable exclusions, are reported on Part I or Part II of Form 8949.8 The filing taxpayer must complete a line with the information on the sale of the home on columns (a) through (e) as instructed. Then, the full gain is adjusted by any amount that is to be excluded (if applicable) on column (g), and the code “H” is entered in column (f).9 The adjusted gain is then entered in column (h), and the adjusted amount of gain will eventually flow through to the taxpayer’s Form 1040 Schedule D and, ultimately, to Line 13 of the taxpayer’s Form 1040.
In wrapping up, here are a few quick notes related to this exclusion. First, although the rules involved would exceed the scope of this article, it’s important to note that when taxpayers fail to qualify for the full exclusion by operation of the rules discussed above, the taxpayer may yet still qualify for a reduced exclusion amount. Second, it may be relevant to note that the taxpayer may elect to have a gain be taxed even though the taxpayer’s sale of a home qualifies for gain exclusion10–depending on the circumstances of the taxpayer, this could actually be a smart move. Finally, it’s important to remember that if a taxpayer sells their main home at a loss, in nearly all cases that loss is not deductible by the taxpayer.11
- See IRC § 121(a).
- IRC § 121(a) (“Gross income shall not include gain from the sale or exchange of property if … such property has been owned and used by the taxpayer as the taxpayer’s principal residence”).
- Treas. Reg. § 1.121(b)(1).
- IRC § 121(a).
- See IRC § 121(b)(3).
- IRC § 121(b)(1)-(2).
- IRC § 121(b)(4).
- See IRS Publication 523 “Selling Your Home”, p. 19, http://www.irs.gov/pub/irs-pdf/p523.pdf.
- See IRS Form 8949 Instructions, p. 6, http://www.irs.gov/pub/irs-pdf/i8949.pdf.
- IRC § 121(f).
- See IRS Publication 523 “Selling Your Home”, p. 2, http://www.irs.gov/pub/irs-pdf/p523.pdf. Although losses on sales of homes generally cannot be deducted by the taxpayer, see Publication 523 for situations in which the taxpayer must nevertheless report the sale of the home that results in a loss to the taxpayer.