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
In a red-hot market for home sellers, taking advantage of the federal income tax principal residence gain exclusion break can be a major tax-saver. You must pass the ownership and use tests and avoid the anti-recycling rule to claim the maximum gain exclusion of $250,000, or $500,000 for married joint-filers.
How do you qualify for exclusion treatment on the sale of a principal residence? ›
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. Some exceptions apply for those who become disabled, die, or must relocate for reasons of health or work, among other situations.
What are the two rules of the exclusion on capital gains for homeowners? ›
Is there a way to avoid capital gains tax on the selling of a house? You will avoid capital gains tax if your profit on the sale is less than $250,000 (for single filers) or $500,000 (if you're married and filing jointly), provided it has been your primary residence for at least two of the past five years.
How do I avoid capital gains on sale of primary residence? ›
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 can be deducted from capital gains when selling a house in the IRS? ›
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.
What is a simple trick for avoiding capital gains tax on real estate investments? ›
Use a 1031 exchange for real estate
Internal Revenue Code section 1031 provides a way to defer the capital gains tax on the profit you make on the sale of a rental property by rolling the proceeds of the sale into a new property.
At what age do you not pay capital gains? ›
Capital Gains Tax for People Over 65. For individuals over 65, capital gains tax applies at 0% for long-term gains on assets held over a year and 15% for short-term gains under a year. Despite age, the IRS determines tax based on asset sale profits, with no special breaks for those 65 and older.
How long do I have to buy another house to avoid capital gains? ›
How Long Do I Have to Buy Another House to Avoid Capital Gains? You might be able to defer capital gains by buying another home. As long as you sell your first investment property and apply your profits to the purchase of a new investment property within 180 days, you can defer taxes.
How many times can I use the primary residence exclusion? ›
Frequency: You can only claim this exclusion once every two years. So, if you have already excluded gains from a previous home sale within the last two years, you will need to wait before you can claim it again.
Is $500,000 exempt from capital gains tax? ›
You can sell your primary residence and be exempt from capital gains taxes on the first $250,000 if you are single and $500,000 if married filing jointly.
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.
What is the 6 year rule for capital gains tax? ›
CGT 6-Year Rule
Allows temporary renting of PPOR for up to 6 years while still claiming main residence exemption. – Each 6-year absence period is treated individually.- No limit on number of times you can use this exemption.- Property must have been your main residence before renting out.
Can a married couple have two primary residences? ›
For example, a married couple could acquire two primary residences if each spouse buys a primary residence and keeps their mortgages separate. This would mean each spouse having sufficient income on their own to buy a home. Additionally, conventional loans can create a second primary residence in some situations.
Can I deduct home improvements from capital gains? ›
Can I deduct home improvements from capital gains? Yes, you can deduct qualifying home improvement costs from capital gains when selling your home. These costs add to the home's cost basis, which reduces the taxable gain.
Are closing costs deducted from capital gains? ›
In addition to the home's original purchase price, you can deduct some closing costs, sales costs and the property's tax basis from your taxable capital gains. Closing costs can include mortgage-related expenses. For example, if you had prepaid interest when you bought the house) and tax-related expenses.
Can you deduct hoa fees from capital gains? ›
No, the HOA fees you pay don't directly lower the capital gains tax you'll have to pay when you sell the rental property. However, you can add the HOA fees you pay over the years to the cost basis of the property. This means they can indirectly reduce the taxable capital gain, though the impact is usually small.
What is qualified principal residence exclusion? ›
The exclusion is intended to apply when qualified principal residence debt was discharged as part of: the restructuring of the loan; the foreclosure of the principal residence; or. the sale of principal residence in a short sale.
Who qualifies for 121 exclusion? ›
Ownership and Use Test for Section 121 Exclusions
This requires that the taxpayer has owned the home and used it as a primary residence for at least 24 months out of the previous 60 months. The 60-month period ends on the date the home is sold. The 24 months do not have to be consecutive.
What are the basic requirements to exclude the gain on the sale of a personal residence quizlet? ›
To satisfy the ownership test, the taxpayer must have owned the residence (house, condominium, trailer, or houseboat) for a total of two or more years during the five-year period ending on the date of the sale.
What is the 121 reduced gain exclusion loophole? ›
Section 121 of the Internal Revenue Code, which is often referred to as the 121 exclusion, generally allows homeowners to sell real property held (owned) and used (lived in) as their primary residence and exclude from their taxable income up to $250,000 in capital gains per homeowner, and up to $500,000 in capital ...
