If you've owned your home for a long time, it may have appreciated significantly by the time you're ready to sell it. If you've owned your home for more than a year, any gain from the sale is taxed at capital gains rates, which are generally lower than ordinary income tax rates. In addition, if you satisfy the criteria, you can exclude some or all of the gain on the sale of your home from taxes altogether.
You can only claim the exclusion of a gain on your primary residence, according to IRS Publication 523. Your primary residence is the home in which you live most of the time and you can only have one primary residence at a time, even if you split your time between multiple homes. For example, if you have a vacation home at which you live two months in the summer, you can't claim the exclusion when you sell that residence.
Criteria for Exclusion
To qualify, you must satisfy the ownership test and the use test. The ownership test requires that you own the home for at least two of the previous five years while the use test requires that you use the home as your primary residence for at least two of the previous five years. The ownership period and the use period do not have to be the same. For example, if you rent the home for two years, then buy it and continue to use it as your primary residence for another year, then use it as a second home for a year, and then sell it, you satisfy both tests. In addition, you cannot have used the exclusion within the two years prior to the sale of your residence.
If you've used the exclusion in the past two years of your sale or fall short of the two years required for the ownership or use test, you may be eligible to claim a prorated exclusion. To qualify, you must be selling your main home due to a change in employment, health reasons or unforeseen circumstances. Examples include if your employer transfers you across the country, you have a medical condition that necessitates living in a different climate, or your home is involuntarily condemned. For example, if you were living in your main home for one year before having to move for your job, you could exclude half the maximum exclusion, or $125,000 of gain.
If one spouse meets the ownership and use tests and you file a joint return, you can exclude $250,000 of the gain from your taxes, as of the time of publication. However, if you file a joint return, both you and your spouse meet the use test, one spouse meets the ownership test and neither you nor your spouse has used the exclusion within the past two years, you can exclude up to $500,000 of gain. If you and your spouse don't meet all four requirements, you can only exclude the amount that each spouse would be permitted to exclude if filing a separate return.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."