How Do You Avoid the Capital Gains Tax on the Profits from a Home Sale?

February 24, 2020 Published by

If you live in the Bay Area and sold your home in the last year there is a good chance you sold it for considerably more than you paid for it. Traditionally, you would need to pay the capital gains tax on those profits. Luckily, the federal government provides a home sale exclusion allowing you to avoid the capital gains tax on the first $250,000 in profit from the sale of your primary residence ($500,000 for married couples)

The federal home sale exclusion included in Internal Revenue Code Section 121 was added to the tax code by the 1997 Taxpayer Relief Act. Prior to that time, taxpayers were required to pay the capital gains tax on any profits from the sale of their primary residence that were not reinvested into a more expensive home.

In return for allowing for taxpayers to avoid the capital gains tax Section 121 does place some restrictions on how and when a taxpayer is allowed to take advantage of the home sale exemption.

Two Year’s Occupation Needed to Qualify

The IRS applies a “use test” to see if a home qualifies for the exclusion. Under the use test, you must have owned and lived in a residence for two out of the five years prior to selling the residence. The occupation need not be continuous, so you can live in a residence, move out for several years, then move back in and have the home qualify, so long as you lived there for a total of two out of the five years.

Since it is possible for an individual or couple to satisfy the use test on two residences that are sold the same year by occupying the second residence two of the three years they were allowed to be absent from the first, taxpayers are only allowed to claim the exclusion every two years.

Use Test Modified in Certain Circumatances

If you fail to qualify under the use test, you are still allowed a prorated exclusion if you sold the home under specific circumstances. Those include selling the home due to a change of employment, health reasons or some other unforeseen circumstance. While you could not claim the entire exclusion, you could still exclude some, or most, of your gains. In other words, if a couple lived in a home for 18 months, but needed to leave town for a new job, they would still be allowed a $375,000 exclusion (18/24 x $500,000).

People who need to leave their home for a nursing home can take advantage of the exclusion if they owned their home and lived there for at least one of the preceding five years. The taxpayer is also allowed to count time spent in the nursing home as time spent in their own home for the purposes of determining if he or she used the home for a year.

How Does a Home Office Change the Equation?

Generally, if your home office is located in the residence you sold for a profit you do not need to allocate the gain between the office and the rest of the house and you may claim the entire exclusion. However if the office lies outside the walls of your home, let’s say in a guest house or repurposed unattached garage, things get more complicated.

If your home office was not located within the walls of your home, the profit from the sale of the home must be allocated between the residence and the unattached office (assuming they are sold as a single property). If your office was in an unattached garage and its floor space was 25% of the combined floor space of the home and garage, you would pay the capital gains tax on 25% of the profit from the sale of your home. In that scenario, if you sold your home for $400,000, you would pay the capital gains tax on $100,000 (25% of $400,000).

While it will not affect your exclusion amount, you will be taxed on any claimed deprecation deductions on the home office taken after May 1997. The “recaptured” depreciation is then taxed at a maximum rate of 25%, not the standard capital gains rate. Thus, if you are married and claimed $5,000 in total depreciation on your home office before the sale, you pay a tax of $1,250.

Which Taxpayers Qualify for the Exclusion?

Married couples will qualify for the $500,000 capital gains exclusion if they filed a joint return for the year, at least one of the spouses meets the ownership test and both spouses meet the use test. If either spouse claimed the exclusion during the preceding two years, the other is allowed a $250,000 exclusion if he or she did not also claim it during that time.

If one spouse died and the survivor then sells the home, he or she qualifies for the entire $500,000 married exclusion if the sale takes place within two years of the death of the spouse and the other spousal requirements were met prior to the death.

Finally, if an unmarried couple has joint ownership of a residence, they are each allowed a $250,000 exclusion.

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This post was written by Sean Allaband

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