If you’re planning on selling your home, even years from now, you’d do well to familiarize yourself with the IRS’s Section 121 exclusion on home sales.
According to Maryann Reyes, a principal with the tax and advisory firm WithumSmith+Brown, here’s what it boils down to: “If you’re selling your home, you don’t necessarily have to pay tax on the gain.”
That capital gains exclusion on home sales has far-reaching implications from a financial-planning perspective and may even inform your decisions about where to live. Reyes walks us through the details of the home sale exclusion so you can take full advantage when the time comes.
What Is the Section 121 Home Sale Exclusion?
By default, anyone who sells a home is subject to pay taxes on their gains—that is, on the difference between how much they sold their house for and how much they initially paid for it. If you bought a house for $125,000 last year and sold it tomorrow for $200,000, you’d owe taxes on your $75,000 windfall.
But the IRS home sale exclusion lets you keep some—or all—of your gain tax-free. This applies to any taxpayer who meets a few simple criteria, and it can mean holding onto thousands of dollars and putting them to work for you, not the government.
How Much Can You Exclude from a Home Sale?
“If you’re a married taxpayer, you’re allowed to exclude up to $500,000 of a gain,” Reyes says. For single filers, the amount is half that, or $250,000.
Let’s look at a few examples:
Example 1: You and your spouse bought your home for $200,000 and sold it for $700,000 (for a $500,000 gain). You owe no tax on any of the $500,000.
Example 2: You’re single, bought a home for $200,000 and sold it for $700,000 (again, for a $500,000 gain). You may exclude $250,000 but owe tax on the other $250,000 of gain.
Example 3: You and your spouse bought a home for $500,000 and sold it for $1.2 million (for a $700,000 gain). You may exclude $500,000 from taxation but owe tax on the other $200,000 of gain.
Reyes adds that qualifying home improvements, such as adding a new roof or furnace, can increase your home’s cost basis, which is the amount used to calculate your gain when you sell. “These are improvements that go above and beyond normal repairs,” she says. “They’re added to your cost basis, which reduces your taxable gain.”
So, to use a fourth example, imagine that you and your spouse paid $300,000 for a home and put in a new roof and furnace at a cost of $60,000. Those improvements increase your tax basis to $360,000. If you then sell the house for $870,000, you can take your full $500,000 exclusion and only owe tax on the remaining $10,000 of gain.
How to Qualify for the Home Sale Exclusion
The IRS puts limits on who can take advantage of the home sale exclusion. “They want to make sure you’ve owned and lived in the home as your primary residence for at least two of the five years before the sale,” Reyes explains.
Take note that there are two criteria there:
- You must have owned the home for at least two of the five years before the sale.
- You must have used the home as your primary residence for at least two of those five years.
For married couples filing jointly, the requirements differ slightly: Either spouse must meet the ownership test, but both spouses must independently meet the use test. In other words, both must have used the home as their primary residence for at least two of the five years before the sale.
Thanks to this two-year ownership and use test, some people refer to the exclusion as a “principal residence exclusion” or “primary residence tax exclusion.”
The two years don’t have to be consecutive. Congress designed the rule to accommodate real-life interruptions such as temporary job locations or renting out the home for a time while still ensuring that the exclusion would be available only to people who genuinely used the property as their principal residence.
There’s also a special rule for certain federal employees. If you or your spouse is away from your home on qualifying military, Foreign Service, intelligence community, or Peace Corps duty, you may be able to “pause” the normal five-year ownership-and-use test for up to 10 years.
Can You Claim the Exclusion More than Once?
You can certainly use the 121 home sale exclusion more than once in your life. However, Reyes adds, “This is not an exclusion you can use every year, thanks to the two-out-of-five-years rule.”
In some cases, timing can really matter. “Imagine a newly married couple,” Reyes begins, “they would both be subject to that two-year rule. If one of them, prior to the marriage, had just used that exclusion, and then together they decide to sell the home that the other spouse had been living in for 10 years but which they have not yet been living in for two years as a couple, they wouldn’t be entitled to the full amount of the exclusion.”
When You May Qualify for a Partial Exclusion
In some cases, if you don’t meet the ownership and use test, you can still get a partial exclusion prorated to the amount of time you used the home as your primary residence.
These cases include changes in employment (such as being transferred by your company to a new workplace at least 50 miles farther away than your previous work location), needing to move for qualifying health-related reasons, and unforeseen circumstances including death, divorce, and natural disasters. The special circumstance must have been the primary reason for the home sale.
How Rental or Business Use Affects the Exclusion
Some properties are considered “mixed-use homes” because they’re both primary residences and workplaces, or because one portion of the home is rented out while the owner lives in another part of the house.
In such cases, the rules become more complicated. For a simple home office, you can generally exclude the gain on the sale of the entire home just as if there were no office, although any depreciation deductions you claimed for business use in earlier years are subject to taxation (a practice known as “depreciation recapture”).
For most other scenarios, homeowners can still claim the home sale exclusion, but they may also be subject to depreciation recapture and may owe tax on the portion of the gain attributable to rental or other nonqualifying use.
How to Report a Home Sale on Your Tax Return
“You always need to report the sale of a home,” Reyes says. “At closing on the sale, you’ll be issued a Form 1099-S, which reports the proceeds on the sale.”
To take advantage of the exclusion when you file your taxes, you’ll complete Schedule D and Form 8949. If you file your own taxes, are comfortable with mainstream tax software tools, and your situation is straightforward, Reyes says that you can probably manage the exclusion without help. “Most of these tools will guide you and provide the steps for you to report it on your own.”
However, she cautions, if your gain is sizable, if yours is a mixed-use case, and especially if your gain is close to the exclusion limit, you’d be wise to get some professional help. “You want to make sure that if you can reduce your gains, you’re able to,” she says.
