FREE NEWSLETTER

Tax Shelter

Richard Connor

MY WIFE AND I recently took advantage of one of the most valuable tax breaks for the typical American family. The tax code provides a generous exemption on the profit from the sale of a primary home. Although this is widely known, it also—based on my conversations with a variety of people—seems to be widely misunderstood.

The Taxpayer Relief Act of 1997 made a major change to the taxation of home sales. Prior to this, owners typically had to roll the full amount from a home sale into another home purchase within two years to avoid paying the capital gains tax. This is no longer the case, but many people seem to think the restriction is still in place.

The 1997 law was very beneficial to homeowners. It exempted from taxation a capital gain of up to $250,000 on the sale of a personal residence by a taxpayer who was single, and up to $500,000 on a sale by a married couple filing jointly. If you want to understand how this tax break works, IRS Tax Topic 701 provides an excellent starting point. From there, you’re directed to IRS Publication 523 for the details.

Want to take advantage of this tax break? First, the sale needs to qualify for preferred tax treatment. The seller must meet an ownership, use and look-back test. Specifically, you must have:

  • Owned the house as your main home for a total of at least two years in the five years before the sale.
  • Used the house as your main home for a total of at least two years in the five years before the sale.
  • Not used the exclusion in the previous two years.

Even if you meet the ownership and use tests, you aren’t eligible for the exclusion if you excluded the gain from another home sale during the two years prior to your latest home sale. This being the tax code, there are exceptions to the “only one tax break in two years” rule. These include exceptions for divorced spouses, widowed spouses, and taxpayers on military and other government service. You also might be eligible for a partial exclusion of the gain if the main reason for your home sale was a change in workplace location, a health issue or an unforeseeable event. IRS Publication 523 provides more details.

Our Free Newsletter

Do you have to report the sale on your federal tax return? It depends. If you receive a Form 1099-S, which lists proceeds from a real estate transaction, you must report the sale, even if the profit is excludable. Sellers must also certify that they met the tests listed above.

In general, a 1099-S must be provided by the company responsible for closing the real estate sale. That’s not necessary if the seller was single and the sale price was less than $250,000, or the sellers were married and the sale price was less than $500,000.

Properly calculating the gain from your home sale is key to the process. The IRS defines the gain or loss as the selling price, minus selling expenses and the home’s adjusted cost basis. The latter would include the original purchase price plus certain home improvements. Publication 523 provides a useful worksheet to guide you through the calculation. Maintaining good records of your home’s purchase and any improvements is critical to an accurate calculation.

We sold our suburban Philadelphia home in March 2021 for slightly less than $500,000. At the time of settlement, we filled out a “certification for no information reporting on the sale or exchange of a principal residence.” This form determines whether the closing agent is required to report the sale or exchange to the IRS on a Form 1099-S. Because the sale was for less than $500,000, we met the appropriate tests, and we’re married and file a joint return, no 1099-S was created. Result: We didn’t have to report the sale on our federal tax return.

Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. He enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. Follow Rick on Twitter @RConnor609 and check out his earlier articles.

Do you enjoy HumbleDollar? Please support our work with a donation. Want to receive daily email alerts about new articles? Click here. How about getting our newsletter? Sign up now.

Browse Articles

Subscribe
Notify of
13 Comments
Inline Feedbacks
View all comments
DrLefty
DrLefty
14 days ago

The first sentence of this article refers to the capital gains exclusion on a home sale as a tax break for the “typical American family.” These days, I wonder if that’s true (the “typical” part).

It’s struck me many times that being able to deduct your mortgage payments and property taxes, profit on a home sale, contributions to retirement accounts, and even charitable contributions is a form of government welfare to the upper-middle class. You have to have adequate/disposable income to be able to fund any of those things. I have two adult children who are millennials. I don’t know if they’ll ever own a home unless they inherit resources from their grandparents or from us. And that’s not because of too many lattes or avocado toasts. It’s just too expensive. What will the finances of the “typical American family” look like 20 years from now?

Carl Book
Carl Book
10 days ago
Reply to  DrLefty

Perhaps we should eliminate all deductions and credits; and also reduce tax rates.

SCao
SCao
14 days ago

Thank you for this very helpful article and timely. We are planning to sell our house next year after owning it for about 12 years now.

Jofi Joseph
Jofi Joseph
17 days ago

Technical comment: even if a 1099-S is not issued, you are still required to report the proceeds from a home sale on your tax return (and demonstrate that you qualify for the primary residence exclusion). This is no different than if you receive income from another entity, you are still required to report it even if you do not receive a corresponding 1099-MISC or 1099-NEC form. Now, in practice, the odds the IRS will follow up with you when no 1099-S is issued is next to nil, but the requirement is still there.

Policy comment: when people wonder why housing prices have gotten so out of whack in our country, the Primary Residence exclusion is a contributing factor, as it effectively subsidizes home sale values. If Bob sells Amazon stock at a $250,000 profit after holding it for two years while Sally sells a primary residence for a $250,000 profit after living in it for two years. only Bob pays taxes on his capital gain. I remain flummoxed as to why anyone believes this is fair or good policy.

Jofi Joseph, CPA

Carl Book
Carl Book
10 days ago
Reply to  Jofi Joseph

If a couple have outgrown their home and move to a bigger house, is it fair to tax them on the gain on the first house? The gain, to a certain extent, is due to inflation caused by government policies.

DrLefty
DrLefty
14 days ago
Reply to  Jofi Joseph

We sold our home in 2019 and had a profit of just over $550,000. (We live in California and had owned it for more than 20 years.) Between sales costs and improvements, we didn’t have to pay any taxes on the excess over $500,000. I don’t recall getting a 1099-S, but I reported the sale on my taxes, as it was part of the interview for the H&R Block software we use. Something went awry, though, and we ended up getting audited. But I was able to convince the IRS that we didn’t owe any money on the sale. It just took some extra paperwork, and thankfully I’d kept complete and well-organized records.

Rick Connor
Rick Connor
17 days ago
Reply to  Jofi Joseph

Joi, thanks for the thoughtful comments. My understanding (per IRS Publication 523) page 16 is there are three conditions (1)taxable gain and you don’t qualify for exclusion, 2) you receive a 1099-S, or 3) you choose to not use the exclusion) that if any are true you must report the sale. Pub 523 says “If NONE of the three bullets above is true, you don’t need to report your home sale on your tax return”. Am I misinterpreting that part of the instructions?

William Perry
William Perry
16 days ago
Reply to  Rick Connor

Hi Rick,
Often the seller closing statement says in the fine print that it is a substitute form 1099-S. As a paid tax preparer my default is to assume the title company has issued a 1099-S and I am always trying hard to prevent possible IRS computer match-up differences and prevent the involvement of a human IRS agent and the accompanying processing delay on the client 1040 or notices.
My reading of the 1099-S instructions regarding the exceptions to filing a 1099-S is that the title company may choose to report the sale even when the exemption applies and I expect many do. How does the seller know for sure what the title company did? By reporting all sales the title company avoids obtaining and maintaining exemption documentation or having to argue that the exemptions are valid. The possible tax penalties for failure to file forms 1099-S and late filing assessments can get very expensive to the title company and may occur years after the year the sale occur.
Also my understanding is that IRS Publications you cite are not law, or one of the primary sources that a taxpayer may rely upon. Pubs are usually considered unofficial guidance which the IRS usually follows except when they do not. The former IRS Taxpayer Advocate Nina Olsen recommendation was to change the IRS stance on unofficial guidance by displaying a warning to taxpayers that such guidance is not binding on the IRS which is now included on IRS FAQs, not yet on IRS Pubs. I am not holding my breath.
Thank you for volunteering your time to help people with their taxes.

Jofi Joseph
Jofi Joseph
16 days ago
Reply to  Rick Connor

Thanks, Rick, you are correct here, based on the language in the IRS Publication. Frankly, I am surprised as you are generally required to report all income received, even if the income ultimately is not taxable. Thanks for the source citation here.

mytimetotravel
mytimetotravel
17 days ago

Unfortunately, the amount of the exclusion has not been updated to account for inflation. It seemed generous when first enacted, but less so twenty five years later. I am getting ready to sell my house, but I am single and have lived in it for over 30 years. Provided house prices don’t nose dive before I sell, my gain will exceed the exclusion. I am busy going through my records and rereading IRS 523 to try to increase my basis….

Paula Karabelias
Paula Karabelias
16 days ago
Reply to  mytimetotravel

We just went throught that with our house. The list of allowed improvements is fairly long. We were able to easily increase the basis enough to avoid the tax.

mytimetotravel
mytimetotravel
16 days ago

It is more difficult if you are single – like twice as difficult…. Also, depends on how long you have owned the house – I would not have had a problem if I had sold ten or even five years ago.

parkslope
parkslope
17 days ago
Reply to  mytimetotravel

My wife and I also had large capital gains above the exclusion when we sold in 2019. In addition to the tax bite, the non-excluded income pushed us into a higher IRMAA bracket. However, we were able to successfully appeal the IRMAA increase because we had qualifying life events that year (we both retired).

Free Newsletter

SHARE