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.

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.

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