The principal residence exclusion is a rule used by the Internal Revenue Service that allows people meeting certain criteria to exclude up to $250,000 for single filers or up to $500,000 for married filing jointly in capital gains tax from the profit they make on the sale of their home.
Key Takeaways
- To qualify for the principal residence exclusion, you must have owned and lived in the property as your primary residence for two out of the five years immediately preceding the sale.
- The two years do not have to be consecutive.
- Some exceptions apply for those who become disabled, die, or must relocate for reasons of health or work, among other situations.
Qualifying for the Principal Residence Exclusion
You must meet the ownership and use tests to qualify for the principal residence exclusion.
To pass the ownership test, you must have owned the property you are selling for at least 24 months out of the five years leading up to the date of sale, defined by the IRS as the closing date. If you are part of a married couple, only one spouse has to be listed as the owner of the property for both to pass the ownership test.
Important
To pass the use test you must have used the home as your primary residence for at least 730 days (24 months) in the five years immediately preceding the closing date of your home’s sale. If you are part of a married couple, both spouses must have individually used the property for 24 out of the last 60 months in order to qualify for the full principal residence exclusion.
Qualifying for a Partial Exclusion
If you don’t fully pass the ownership and use tests, and you have a valid excuse for why you couldn’t stay the two years, you can qualify for a partial exclusion with the percentage of the exclusion directly proportional to the percentage of time you were in your home.According to the IRS, valid excuses include health-related or work-related moves or unforeseen circ*mstances. If, for example, your excuse is approved and you were in your home for one out of the last five years, then you have met 50% of the use requirement and can qualify for 50% of the exclusion on gains: $125,000 for single filers and $250,000 for married filing jointly.
Exceptions
- Prior to 1997, individuals over the age of 55 did not have to pay capital gains taxes on their home and other property sales. In 2022, these adults have no such privileges but there are other exceptions to the two-out-of-five-year ownership and use tests.
- Official Extended Duty: If one or both of the individuals selling a home (in the case of a married couple) is on official extended duty in the Foreign Service, intelligence community, or uniformed services they can elect to suspend the five-year ownership and use test period for up to 10 years. To meet the qualification of “official extended duty,” an individual must be at a duty station that is at least 50 miles from their main home or residing under government orders in government housing for at least 90 days.
- Disability: You may qualify for the full principal residence exclusion if you become physically or mentally unable to care for yourself. You can count time spent in a care facility licensed to care for people with your condition towards your two-out-of-the-last-five-years use requirement.
- Death or Divorce: In the event of death or divorce, you may be able to meet certain exceptions to the ownership and use test. Widowed spouses can count the time their spouse lived in the home toward the requirement for two out of five years' residence. Divorced spouses may be able to count time that their spouse owned the home toward the ownership test but will still have to meet the use test themselves.
Other Ways to Reduce or Avoid Paying Capital Gains Tax
If you are unable to meet the requirements for the principal residence exclusion and you don’t qualify for any of the main exceptions, you may still be able to avoid paying capital gains tax when selling your property.
- 1031 Exchange: The 1031 exchange is a like-for-like exchange that allows individuals to defer paying capital gains tax on their property sale by immediately investing the proceeds into a substantially similar property.This exchange is only available if you are selling an investment property, and it is a complex process. Consult with a tax professional or a 1031 exchange company to ensure you qualify and complete the steps correctly.
- Tax-Loss Harvesting: If you have an investment with an unrealized loss you are considering selling, you may be able to take advantage of tax-loss harvesting to offset the capital gains from the sale of your home. Remember that selling an investment at a loss just to offset capital gains taxes may not be the best financial decision since the investment you sell at a loss may rise in value more than the taxes you will be saving.
- Calculate Your Basis Correctly: You pay capital gains tax only on your profit on the home sale, which is the sale price minus your cost basis in the property. Make sure that you correctly calculate your cost basis by including the price you paid for the home, all transaction costs associated with buying and selling the home (realtor commissions, title fees, and so on), and any meaningful improvements you made to the property with a useful life of more than one year.
The Bottom Line
The principal residence exclusion is one of the easiest ways to reduce or eliminate capital gains taxes when selling your home. Be sure to live in your home for 24 out of the 60 months prior to your closing date to qualify for the exclusion. As always, when working with complex Internal Revenue Service rules, regulations, exclusions, and exemptions, consider consulting with a tax planning professional to see what is best for your individual situation.
FAQs
The Bottom Line. The principal residence exclusion is one of the easiest ways to reduce or eliminate capital gains taxes when selling your home. Be sure to live in your home for 24 out of the 60 months prior to your closing date to qualify for the exclusion.
How do I avoid capital gains on sale of primary residence? ›
As long as you lived in the property as your primary residence for 24 months within the five years before the home's sale, you can qualify for the capital gains tax exemption.
What is the $250000 ($500,000) home sale exclusion? ›
If you meet certain conditions, you may exclude the first $250,000 of gain from the sale of your home from your income and avoid paying taxes on it. The exclusion is increased to $500,000 for a married couple filing jointly. This publication also has worksheets for calculations relating to the sale of your home.
How does the 121 home sale exclusion work? ›
The Basics of Section 121 Exclusions
The Section 121 Exclusion, also known as the principal residence tax exclusion, lets people who sell their primary homes put the proceeds from the sale into another home without having to pay taxes on the gain.
How do you calculate capital gains tax on the sale of a home? ›
Capital gain calculation in four steps
- Determine your basis. ...
- Determine your realized amount. ...
- Subtract your basis (what you paid) from the realized amount (how much you sold it for) to determine the difference. ...
- Review the descriptions in the section below to know which tax rate may apply to your capital gains.
A few options to legally avoid paying capital gains tax on investment property include buying your property with a retirement account, converting the property from an investment property to a primary residence, utilizing tax harvesting, and using Section 1031 of the IRS code for deferring taxes.
How to avoid paying capital gains tax on sale of rental property? ›
You can avoid paying this tax by using the 1031 deferred exchange or tax harvesting. Alternatively, you can convert your rental property to a primary residence or invest through a retirement account. Don't forget to insure your property with Steadily to avoid making losses after investing in real estate.
At what age do you not pay capital gains? ›
Since there is no age exemption to capital gains taxes, it's crucial to understand the difference between short-term and long-term capital gains so you can manage your tax planning in retirement.
Do you pay capital gains after age 65? ›
Whether you're 65 or 95, seniors must pay capital gains tax where it's due. This can be on the sale of real estate or other investments that have increased in value over their original purchase price, which is known as the “tax basis.”
How long do you have to reinvest money from sale of primary residence? ›
If the home is a rental or investment property, use a 1031 exchange to roll the proceeds from the sale of that property into a like investment within 180 days.13.
You can avoid capital gains tax when you sell your primary residence by buying another house and using the 121 home sale exclusion. In addition, the 1031 like-kind exchange allows investors to defer taxes when they reinvest the proceeds from the sale of an investment property into another investment property.
What is the one time capital gains exemption? ›
If you have a capital gain from the sale of your main home, you may qualify to exclude up to $250,000 of that gain from your income, or up to $500,000 of that gain if you file a joint return with your spouse. Publication 523, Selling Your Home provides rules and worksheets.
How many times can you use the home sale exclusion? ›
You're only allowed to exclude gain on the sale of a home once every two years. This is true unless the reduced gain exclusion rules apply.
What is the 6 year rule for capital gains tax? ›
What is the CGT Six-Year Rule? The capital gains tax property six-year rule allows you to use your property investment as if it was your principal place of residence for up to six years whilst you rent it out.
How much do you pay the IRS when you sell a house? ›
It depends on how long you owned and lived in the home before the sale and how much profit you made. If you owned and lived in the place for two of the five years before the sale, then up to $250,000 of profit is tax-free. If you are married and file a joint return, the tax-free amount doubles to $500,000.
Do I have to pay capital gains tax immediately? ›
This tax is applied to the profit, or capital gain, made from selling assets like stocks, bonds, property and precious metals. It is generally paid when your taxes are filed for the given tax year, not immediately upon selling an asset.
How to not get hit on capital gains tax when selling a house? ›
You can avoid capital gains tax when you sell your primary residence by buying another house and using the 121 home sale exclusion. In addition, the 1031 like-kind exchange allows investors to defer taxes when they reinvest the proceeds from the sale of an investment property into another investment property.
Do you have to pay capital gains if you reinvest in another primary residence? ›
Do I Pay Capital Gains if I Reinvest the Proceeds From the Sale? While you'll still be obligated to pay capital gains after reinvesting proceeds from a sale, you can defer them. Reinvesting in a similar real estate investment property defers your earnings as well as your tax liabilities.
What happens if you sell a house and don't buy another? ›
Understanding the Potential Cost of Capital Gains Tax. Selling a house without buying a house can provide a windfall of cash to the seller. However, the seller could be in for a rude awakening at tax time depending on the circ*mstances and the amount of profit. This is due to capital gains.
