Although the government has chipped away at some of the biggest tax shelters for individuals, at least one solid foundation is still standing: your home. During the period when you own a home, it can be a source of valuable tax deductions for mortgage interest and property taxes. Even better, if you sell the home at a huge profit, you may be able to pocket all or most of the gain from the sale—tax-free.
By making a special election on your tax return, you can exclude from taxable income up to $250,000 of gain—$500,000 if you’re married and file a joint return—from the sale of your home. The election is made for the tax year in which the home sale occurred.
Background: To qualify for the $250,000/$500,000 home-sale tax break, the home must have been owned by you and used as your principal residence at least two of the five years prior to the sale. (Certain individuals who are moving to a nursing home may have to meet this requirement for only one out of the past five years.) This special tax exclusion doesn’t apply, however, if you sold another qualified principal residence within the past two years. Theoretically, you could qualify for the home-sale exclusion every two years. The old rules for a “once-in-a-lifetime” exclusion are now a distant memory.
With that in mind, here are five key points about the home-sale exclusion:
- The home must have been used as your principal residence for any two of the past five years. The years do not have to be consecutive. Moreover, you can meet the “use” and “ownership” requirements in different tax years.
- If you file a joint return, you can claim the maximum exclusion if (1) either spouse meets the two-year ownership test, (2) each spouse meets the two-year use test and (3) neither spouse has elected the exclusion within the past two years. This is particularly important to remember if you have recently married, divorced or remarried.
- To meet the use requirement, you must physically occupy the home, but short absences won’t count against you. On the other hand, a longer absence, such as a one-year sabbatical by a college professor, does not count as time that the home was used as your principal residence.
- If you own two homes and live in both places during the year, the home where you stay for most of the year is generally treated as your principal residence. For instance, if you spend seven months at a winter home and five months at a summer home, the winter home is considered your principal residence.
- To the extent that the home has been used for business rental or use—including using a portion of the residence as a home office—you must recapture depreciation deductions attributable to the period after May 6, 1997. The recaptured income is taxed at the 25% rate.
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