If the original purchase price of your home is much less than the price you can currently sell it for, you may be concerned about the tax implications of the sale. It's not until the year in which the deed transfers to the buyer that you'll have a capital gain. You may, however, have a chance of avoiding the capital gains tax altogether if it's your main home.
Capital Gains Rule
Your home, regardless of whether it's purchased as an investment or for personal use, is a capital asset. This means that when you sell it for more than your basis -- which is the price you paid for it plus the cost of permanent improvements you make -- the result is a capital gain. Since the tax owed on the gain depends on how long you owned the home, you need to determine whether it's short-term -- meaning you owned the home for one year or less before selling it -- or long-term -- which is property you own for more than one year. The difference can be significant, as net short-term gains are taxed at the same rates you pay on most of the other income you earn. Long-term capital gains, however, are taxed at zero, 15 or 20 percent. The rate you'll pay on long-term gains depends on what your marginal rate of income tax is for the year.
Main Home Gain
The federal government offers a substantial tax benefit by allowing you to exclude some of the gain from the sale of your main home -- the place you live most of the time -- if you can satisfy the ownership and use tests. If you can, up to $250,000 of the gain -- or $500,000 for eligible married couples -- can be excluded from your tax return. In situations where you can't satisfy every requirement, you may be able to exclude a smaller amount of gain if your reason for selling is because of a new job, your health or other unforeseen circumstances. Lastly, the law doesn't allow the gain exclusion if within the two-year period that ends on the day the deed transfer is effective you excluded gain on a prior main home.
Ownership & Use Requirements
Both tests are met if during the five-year period ending on the day the sale of your main home is finalized you owned the home and lived there for two years. Your ownership and use, however, need not cover consecutive two-year periods or have to be the same two years to exclude the capital gain.
If you're married and file a joint return in the year the home is sold, you may qualify for the larger $500,000 gain exclusion. The two tests still apply, but for the ownership test, either you or your wife must be able to satisfy its requirements -- but not both of you. However, if either of you excluded gain on the sale of a main home during the two-year period, the maximum gain you can exclude is $250,000.
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