Under the Taxpayer Relief Act of 1997 and effective for property sales after May 6, 1997, home sellers will not pay taxes on capital gains in excess of $250,000 ($500,000 for a married couple filing jointly) on the sale of their home. Generally, if you can exclude all the gain, you do not need to report the sale on your tax return.
You will pay taxes on a home sale on amounts of gain in excess of the excludable amount. This type of gain will be taxed at the capital gains tax rate. If you have a loss on the sale, you cannot deduct it on your return. However, you may need to report it.
To qualify for the tax exclusion on your home sale you must meet the following IRS requirements:
1. Ownership Test - Owned the home for at least 2 years
2. Use Test - Lived in the home as your primary residence for at least 24 months within a 5 year period prior to the sale, (not necessarily consecutive), and
3. During the 2-year period ending on the date of sale, you did not exclude gain from the sale of another home.
Definitions
Capital Gains Tax - the tax you owed upon the sale of an investment. The increase or decrease in the value of a Capital Asset is taxed when it is sold. The capital gains tax rates are determined by the type of investment asset and the holdingperiod of the asset.
Capital Asset - investments such as stocks, mutual funds, bonds, real estate, precious metals, coins, fine art, and other collectibles. Capital Assets may also produce income (interest, rents) and this income is taxed when it is generated.
Capital Gain - a profit made from the sale of any capital asset where the sale price exceeds the purchase price of the investment.
Capital Loss - a loss made on an investment.
Holding Period - the length of time you have held an investment. The IRS states, "To determine how long you held the investment property, begin counting on the date after the day you acquired the property. The day you disposed of the property is part of your holding period." (Publication 550; also refer to Revenue Ruling 70-598.)
The short-term holding period is one year or less. Short-term capital gains are taxed at ordinary income tax rates. The long-term holding period is more than one year. Long-term capital gains are taxed at long-term capital gains rates, which is usually less than ordinary tax rates.
Exceptions to the 2 out of 5 Year Rule
You can use this 2-out-of-5 year rule to exclude your profits each time you sell or exchange your main home. Generally, you can claim the exclusion only once every two years. If you lived in your home less than 24 months, you may be able to exclude a portion of the gain. Exceptions are also allowed if you sold your house because the location of your job changed, because of health concerns, or for some other unforeseen circumstance.
Change in the Location of Your Job - If you lived in your house for less than two years, you can exclude a part of your gain on the sale of your house if your work location has changed. This exception would apply if you started a new job, or if you are moved to a new location with your employer.
Health Concerns - If you are selling your house for medical or health reasons, be ready to document those reasons with a letter from your physician. Such a letter does not need to be filed with your tax return. Instead, keep the documentation in your personal records just in case the IRS wants further information.
Unforeseen Circumstances - If you are selling your house because of unforeseen circumstances, be ready to document what those reasons are. IRS Publication 523 defines an unforeseen circumstance as "the occurrence of an event that you could not reasonably have anticipated before buying and occupying your main home." The IRS has given specific examples of unforeseen circumstances:
- natural disasters,
- acts of war,
- acts of terrorism,
- change in employment or unemployment that left you unable to meet basic living expenses,
- death,
- divorce,
- separation, or
- multiple births from the same pregnancy.
*In addition to the federal capital gains tax rates, your capital gains will also be subject to state income taxes. Many states do not have separate capital gains tax rates. Instead, most states will tax your capital gains as ordinary income subject to the state income taxes rates.
This brief guide has been prepared solely to help my clients familiarize themselves with Capital Gains relating the sale of their property. Please consult a Tax Professional with specific questions about Capital Gains or call the IRS with further tax questions at 1-800-829-1040.
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