The tax blow for the sale of a principal residence may be softened, even eliminated, by the $250,000 exclusion from income ($500,000 for marrieds filing jointly) for the gain from the sale of a principal residence.  However, these boundaries were set in 1997 and never adjusted for inflation.  As the prices of houses have soared in the past few years, more and more taxpayers find themselves in taxable territory.  Had there been an inflation adjustment, the exclusion for couples would now be $981,558, according to the Bureau of Labor Statistics online calculator.

A recent Wall Street Journal article [“Capital-Gains Tax Hits More Home Sellers,” May 4, 2024] reported that roughly 8% of recent home sales have generated likely taxable gains.  However, there is considerable variation around the country.  California is the leader, with an estimated 28.8% of home sales in the fourth quarter of 2023 resulting in taxation.  Hawaii, Washington, D.C., Massachusetts, and Washington state each were over 15% in the proportion of gains exceeding the exclusion amount.

Long-Term Owners

To be eligible for the full exclusion for a home sale, one must have owned and used the property as a personal residence for at least two of the preceding five years.  Short absences (such as vacations) are not a problem, but a prolonged absence could be.

The doubled exclusion of $500,000 for married couples is available if: (1) either spouse meets the two-year ownership test; (2) both spouses meet the two-year use test and (3) neither spouse has claimed the exclusion within the prior two years.  If one spouse is ineligible, the other may still claim up to $250,000.

Relief for Short-Term Owners

If the two-year test can’t be met, a partial exclusion may be salvaged if the home sale came about due to a change in the place of employment, a change in health or for “unforeseen circumstances.” IRS has provided examples that meet these vague requirements.  For example, the exclusion would be available for a sale due to:

• multiple births from a single pregnancy;
• a lost job;
• a change in circumstances that leads to an inability to meet mortgage payments;
• development of a disease, illness or injury (selling to improve one’s general health would not qualify).

For some taxpayers, a partial exclusion will be as good as full one if it covers the full amount of their gain.

Good Records Are Essential

These rules make good recordkeeping more important than ever.  Good records for current home owners will also be important when:

• the owners intend to stay in the home for a long period of time;
• they have invested heavily in renovations;
• there is a possibility that the owners will claim a depreciation deduction for a home office or rental use of the residence. Gain will have to be recognized to the extent of any depreciation deduction claimed.

The tax on the sale of a home applies to the net after the tax basis is subtracted from the sales proceeds.  Basis includes what the taxpayer paid for the house plus major remodeling, such as a kitchen upgrade or a new roof.  Routine repairs don’t count.  Details on allowable expenses are provided in IRS Publication 523.

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