When you sell an asset for more than you paid for it, the Internal Revenue Service refers to your profit as a capital gain, and it's taxable. The law makes a big exception, however, when the asset in question is your primary residence. Most homeowners in most situations will not have to pay capital gains tax on the sale of their homes.
Under the tax code, the first $250,000 in profit on the sale of your home is exempt from capital gains tax as long as you meet the requirements of the IRS's "ownership test" and "use test," discussed a little later. If you're married and file a joint tax return, the exemption amount doubles to $500,000 if either you or your spouse meets the requirements of the ownership test and both of you meet the requirements of the use test. Once you claim an exemption — or "exclusion," as the IRS calls it — you can't do it again for two years.
Ownership and Use Tests
To qualify for the capital gains exclusion, you must pass two tests. Under the ownership test, you must have owned the home for a total of two years in the five-year period immediately before the sale. Under the use test, you must have used the home as your primary residence for a total of two years during that same five-year period. Those two-year periods don't have to be consecutive — that is, two uninterrupted years of ownership or use. All that matters is that the total time of ownership and the total time of use during that five-year block each add up to two years.
Figuring Your Gain
If you don't qualify to exclude the gain from the sale of your home, capital gains taxes will apply. To determine how much is subject to capital gains tax, take the sales price of the home and subtract any expenses you had to pay to sell it, such as real estate agents' commissions, inspection fees or legal fees. You can also subtract the cost of any major improvements you may have made, such as the addition of a room. The result is your "amount realized" from the sale. From that, subtract your "adjusted basis" on the property. That's the amount you paid for the home, plus closing costs that were necessary to buy the home, such as title transfer fees or survey fees. Closing costs related to obtaining a mortgage, such as origination fees or "points," don't get added to the basis -- they were the cost of the loan, not the home. The amount realized minus your adjusted basis is your taxable gain on the property.
The tax code allows some exceptions to the ownership and use tests for members of the military and intelligence services who are stationed away from their homes, as well as for people forced to sell their homes after the death of a spouse, for health reasons, because of a change in employment, or for other unforeseen reasons. In some cases, the two- or five-year periods may be altered or waived. IRS Publication 523, "Selling Your Home," for details about these special circumstances.
Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.