WHEN TALKING with home sellers, I’ve long ceased being surprised by how many routinely overlook or fail to take maximum advantage of a valuable tax break: the exclusion when unloading their principal residence.
The exclusion—meaning you pay no taxes—is capped at $500,000 for married couples filing jointly and $250,000 for singles and married couples filing separate returns. I frequently need to remind sellers that these exclusions apply to profits, not sales prices. In other words, it’s the amount over and above their home’s cost basis, which includes not only the original purchase price, but also any home improvements and many costs incurred when buying and selling.
Understandably, sellers want to know what they’re likely to shell out for taxes when their profits exceed the applicable exclusion amounts. I tell them that there’s good news and bad news.
The good news: For most sellers, the excess is taxed as a long-term capital gain and the maximum rate is usually 15%, plus applicable state taxes. The bad news: For lots of high-income sellers, the maximum rate increases to 20%. Worse yet, it goes as high as 23.8% for those who are subject to the Medicare surtax of as much as 3.8% on income from certain kinds of investments, including profits from home sales.
The surtax was introduced in 2013 by the Affordable Care Act, popularly known as Obamacare. The 3.8% tax remains on the books, at least for now, because of the collapse of efforts to repeal and replace Obamacare. State taxes, of course, will be on top of that.
The exclusion isn’t a onetime opportunity. Sellers can claim it as often as every two years. To qualify, a seller must pass two tests. First, she has to have owned and lived in the property as her principal residence for at least two years out of the five-year period that ends on the date of the sale. Second, she can’t have excluded the gain on the sale of another principal residence within the two years that precede the sale date.
Contrary to what many sellers mistakenly believe, the two years occupying the home needn’t be consecutive. They can be off and on for a total of two full years. She can count short temporary absences for vacations or other seasonal absences as periods of owner use. This holds true even if she rents out the property during those absences.
The exclusion isn’t limited to the sale of a conventional single-family home. Her principal residence could be a condo, a cooperative apartment, her portion of a multi-unit apartment building, a house trailer, a mobile home or anything else that provides all the amenities of a home, such as a houseboat or yacht that has facilities for cooking, sleeping and sanitation, or even a vacation retreat that she moves into after retirement. Moreover, the location of the principal residence doesn’t matter. It can be in a country other than the U.S.
What if she sold another home within the previous two years or fails to satisfy the ownership and use requirements? She may be able to claim a partial exclusion. To qualify, the primary reason for the sale must be health problems, a change in employment or certain unforeseen circumstances. The IRS’s broad definition of unforeseen circumstances includes divorce or legal separation, or natural or man-made disasters that cause residential damage—hurricanes Harvey and Irma, for instance.
Let’s say a seller is single and has lived in her dwelling for just 12 months before moving to a new job in another city. She can exclude a gain of as much as $125,000—12 months divided by 24 months, or 50% of her maximum allowable $250,000 exclusion.
Julian Block writes and practices law in Larchmont, N.Y., and was formerly with the IRS as a special agent (criminal investigator). His previous blogs include Late? That’ll Cost You 50% and Hitting Home. This article is excerpted from Home Seller’s Guide to Tax Savings, available at JulianBlockTaxExpert.com. Follow Julian on Twitter @BlockJulian.