If you sell your main home for a healthy profit, the gain exclusion privilege can be one of the most valuable tax breaks on the books. If you qualify, you can potentially exclude (pay no federal income tax on) up to $250,000 of home-sale profit or up to $500,000 if you are married and file a joint return with your spouse. Since residential real estate prices are bouncing back strongly in many areas, the gain exclusion break has regained its relevancy. Here’s the second installment of our multi-part series on how you can cash in. (For Part 1, see The most valuable tax break? )
Basic qualification rules
Singles can exclude home-sale gains up to $250,000 and married couples filing jointly can exclude up to $500,000. However, you must pass the following tests.
Ownership test: You must have owned the property for at least two years during the five-year period ending on the sale date. Two years means periods aggregating 24 months or 730 days.
Use test: You must have used the property as your principal residence for at least two years during the same five-year period. Once again, two years means periods aggregating 24 months or 730 days.
Periods of ownership and use need not overlap. For example, you could rent a house and use it as your principal residence for years 1 and 2 and then buy the house and rent it out to others for years 3 and 4. If you sold the house in year 5, you would pass both the ownership and use tests and thereby qualify for the gain exclusion privilege.
Taking advantage of $500,000 exclusion for married joint-filers
To qualify for the larger $500,000 joint-filer gain exclusion, at least one spouse must pass the ownership test and both spouses must pass the use test. When only one spouse passes both tests, the maximum gain exclusion is generally only $250,000. However, if you and your spouse own two houses, you can each potentially claim separate $250,000 exclusions.
Example 1: Say you get married and immediately sell your valuable home, which you had owned and used as your principal residence for many years, for a whopping $600,000 gain. You then file a joint return for the year of sale with your new spouse. Unfortunately, you do not qualify for the larger $500,000 joint-filer exclusion, because your spouse does not pass the use test. Therefore, you must report a $350,000 taxable gain ($600,000 profit - $250,000 exclusion) on your return for the year of sale. Ouch!
Better way: Instead of selling immediately, you and your new spouse should consider living in your home for at least two years after the marriage. That way, you will qualify for the larger $500,000 joint-filer, because you will pass the ownership test and both you and your spouse will pass the use test.
Taking advantage of two separate $250,000 exclusions
If you own two homes and file jointly, each spouse’s eligibility for the $250,000 exclusion is determined separately, and each spouse is considered to own each property for any period the property is actually owned by either spouse (actual ownership doesn’t matter as long as you file jointly).
Example 2: You and your spouse have a commuter marriage and own two homes. You work in San Diego and live most of the time in a condo there. Your spouse works in Washington DC and lives most of the time in a townhouse there. The larger $500,000 joint-filer exclusion is not available for either home, because both you and your
spouse must pass the use test to qualify for the bigger exclusion. However, two separate $250,000 exclusions are potentially available in this situation. Here’s how that would work.
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Assume both homes have been owned for more than a few years. As long as you file jointly in the year when a home is sold, the ownership test will be passed for that home, regardless of whether the home is owned jointly or separately. That’s because, as stated earlier, each spouse considered to own a property for any period the property is actually owned by either spouse. So if the San Diego home is sold, you pass both the ownership test and the test for that property. If the DC home is sold, your spouse would pass both tests for that property.
So on a joint return, you would qualify for a $250,000 exclusion if the San Diego home is sold. Your spouse would qualify for a separate $250,000 exclusion if the DC home is sold. This would be true whether you sell both homes in the same year or in separate years.
If you and your spouse file separate returns, it gets more complicated, but you can still potentially qualify for two separate $250,000 exclusions. In the separate return scenario, actual ownership matters. If you and your spouse own a property jointly and you both live there, you can potentially exclude up to $250,000 of your share of the gain on your separate return if the property is sold. Your spouse can do the same. If you and your spouse own two properties separately and live in them separately, you can potentially exclude up to $250,000 of gain on the sale of your property. Your spouse can do the same on the sale of his or her property.
Special deal for surviving spouses
If your spouse died and you have not remarried, you cannot file a joint return for any year after the year in which your spouse died. Not too long ago, this little rule could have prevented you from taking advantage of the larger $500,000 exclusion that is allowed to joint filers, because you would have been limited to the smaller $250,000 single-filer exclusion if you sold your home in a year after the year in which your spouse died. In 2007, Congress addressed this problem but did not completely cure it.
Under the current rules, an unmarried surviving spouse can claim the larger $500,000 gain exclusion for a principal residence sale that occurs within two years after the spouse’s date of death, assuming all the other requirements for the $500,000 exclusion were met immediately before the spouse died. Beware: since the two-year eligibility period for the larger exclusion begins on the date of the spouse’s death, a sale that occurs in the second calendar year following the year of death but more than 24 months after the date of death won’t qualify for the larger $500,000 gain exclusion. You have to get the timing just right to qualify.
The bottom line
As I said at the beginning, the federal home-sale gain exclusion privilege can be one of the most valuable tax breaks on the books. In a future column, I’ll explain how you may be able to collect a reduced exclusion when you fail to meet all the qualification rules. Stay tuned.
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