Each summer, the real estate market turns into a zoo as buyers and sellers play a big game of musical chairs. Everyone’s trying to get a new seat before the school year starts up again.
Buyers who are also selling a home that has gone up in value will face capital gains taxes…
Or will they?
If you do things right, you can exclude from taxes up to $500k capital gain married filing joint (single filers divide by 2).
In this week’s podcast, I share how the home sale capital gains tax exclusion works, the rules you must follow, and common mistakes sellers make that cut into the tax benefit.
What you’ll learn:
- Basic rules of the home sale capital gains tax exclusion
- The 2009 change that made claiming your exclusion more difficult
- What qualified vs. non-qualified uses are…and how it impacts your tax liability
- The safe harbors that help you exclude more from taxes
Have you sold a home before and were able to get the exclusion? What’s the most confusing part of the rules to you? Let me know by leaving a comment when you’re done.
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Read this episode as a post:
Today I want to talk about the home sale capital gains tax exclusion.
These are the tax rules that apply when you sell your home. They are fairly complex. I’ve actually written a fairly extensive blog post on the Hack Your Wealth blog about this exact topic.
And it’s one of the most highly trafficked posts on the blog. But it is a fairly dense read and it goes through a lot of detailed examples so that you can really get into the weeds of it.
But for today’s episode, what I want to do is summarize the big picture concepts you need to know about how the home sale capital gains tax exclusion works because this is going to be something that’s commonly encountered by basically every homeowner when they sell their home.
And as of the release date of this episode, which is early June, the prime home buying season of the year is starting up right about now, and it’s going to last through the summer.
And unless you’re a first time homebuyer, most people who are buying a home are also selling a home.
So knowing how the tax rules work when you sell a home and how they can be used advantageously so that you can shield your capital gain from taxes is going to be really important as you do tax planning. So that’s why I wanted to time the topic of today’s episode for now.
Before we get to all that though, as always, I want to invite you to join the private Hack Your Wealth Facebook group.
I encourage you to join. It’s a way for us to connect, have a two-way dialogue. I am in there every single day, responding to all the comments and questions there.
And it’s just a place for people to ask about financial independence and early retirement, tax strategies, real estate investing, which is related to what today’s topic is about, side business income, online income, career changes, and just all kinds of advice related to personal finance.
And so I definitely encourage you to join us there. It’s a good group of people. There’s a lot of friendly and helpful people there.
Check it out at hackyourwealth.com/fb.
Let’s jump into the heart of today’s episode.
The basic idea around the home sale capital gains exclusion is that when you sell your house, the capital gain from the sale, basically the profits you made compared to what you paid for the house, are generally going to be taxed a hefty amount, up to 15%. That’s pretty sizable.
But if you do things right, the IRS is actually going to give you a nice tax break. Specifically, you can completely exclude from taxes up to $250,000 in gain if you’re a single filer, or twice that, $500,000 if you’re married filing joint.
So today, I want to share the details around how it works and some of the nuances you have to be aware of so you don’t accidentally disqualify yourself by making a mistake.
So let’s start with the basics.
Who qualifies for the home sale capital gains exclusion?
It is homeowners who are living in their home as their primary residence for at least two of the last five years before selling.
That’s the key. The look back is five years, and you have to be living in your home for at least two of those years. They do not have to be contiguous.
What type of home qualifies?
Basically any home that you can live in. It doesn’t matter if it’s a single-family home, condo, townhouse, or whatever. All that matters is that it’s your primary residence and where you are physically living.
Those are the basic criteria.
And if you follow those basic criteria, and there’s going to be a lot of exceptions and nuances that I’m going to get into in a moment, but if you follow the basic criteria, you can exclude up to $250,000 of gain on the sale of your home if you’re a single filer, half a million dollars if you’re married filing jointly.
Exclusion limited by your actual gain upon sale
If you sell your home and get less gain than those amounts, then the amount that you can exclude is obviously going to be less.
It’s going to be limited to the lower of your actual gain or a quarter million or half a million dollars, depending on your marital status.
Exclusion limited to every 2 years
Now, the trigger that allows you to claim the exclusion is the sale of your home.
Because this is obviously a pretty generous tax break of a quarter million dollars or half a million dollars, you are limited the number of times you can actually do this.
The government only allows you to do this once every two years: which makes sense because you actually have to live in the property for two years, so you wouldn’t possibly be able to do it faster than that.
So just keep in mind that it generally takes two years at a minimum to qualify for the exclusion, and you can’t do it faster than every two years.
Special rule for married taxpayers
Now, if you’re married, there are some special rules that apply.
In order to get the double exclusion amount, the $500,000, there are three conditions you have to fulfill.
One is that at least one spouse must have owned the home for two of the five years before the sale.
Second is that both spouses must actually live in the home as their primary residence for two of the five years before the sale.
Third is that neither spouse can be in a timeout period because of that once every two years rule that I just mentioned a moment ago.
And so you have to generally fulfill all those three things in order to qualify for the full $500,000 exclusion.
Married taxpayers may be evaluated separately in some situations
Sometimes one spouse fails one or more of the criteria, but that won’t knock you out of the exclusion entirely.
What happens is the IRS then considers you separately as if you were not married.
So that means they evaluate each of you independently to see what your own personal exclusion WOULD have been had you been a single filer.
And then it will take whatever the partial exclusion that each spouse may have been entitled to, add them up, and then the sum total of that will be the actual exclusion amount that as a married couple you’re jointly entitled to.
It’s also important to know that when the IRS does this analysis of fictionally separating you two, you get a break on the first criteria, namely that the IRS will treat both spouses as having owned the property as long as either one of the spouses own the property.
So, if only the husband or the wife owned the property, then the other spouse will be deemed to own the property as well.
So, for example, let’s say a woman owns and lives in her own home for three years before getting married.
Then she gets married.
And then one month after she gets married, she decides to sell her house because she and her husband want to move to a new city for new jobs.
Well, in that case, obviously, the husband will fail the two-year residency requirement and the husband doesn’t own the home.
So the IRS will evaluate them separately, but it’s going to assume the husband owned the house for the exact same amount of time that the wife owned the house: three years.
So the husband will pass that part of the criteria, but then will fail the residency criteria.
So then the IRS will take whatever partial exclusion the husband is entitled to, assuming the husband is entitled to any partial exclusion. We don’t necessarily have enough information at this point to determine that.
But if the husband does have any partial exclusion, the IRS will take that portion, add it to whatever the exclusion the wife is entitled to, and then declare that sum total to be what the couple is jointly entitled to.
And we’re going to see some more detailed examples of this later on.
Changes to the rules in 2009
One thing I wanted to point out is that there were some significant changes to this law in 2009 that actually made it harder to claim the tax exclusion.
And that’s just because in 2009, Congress needed to raise more tax revenue. The whole world was in a financial crisis.
So it amended the rules around home sale capital gains tax exclusions to be more restricted.
Before 2009, you only had to meet the two-year residency requirement.
But after 2009, you had to both meet the residency requirement and do some other stuff in order to get the full exclusion.
One of the changes that came about in 2009 is that the IRS said: even if you meet the two-year residency requirement, you can still only claim the tax exclusion for periods of what it calls qualified use.
Any periods that are non-qualified use, you cannot claim the tax exclusion for, even if you fully meet the residency requirement.
And so that introduced this obvious question. What is qualified use versus non-qualified use?
Qualified vs. non-qualified use
And so the IRS clarified this, that non-qualified use is, after 2009, anytime the home is not actually being lived in as a primary residence by either you or your spouse.
Before 2009, as long as you met the two years residency within five years, the IRS didn’t care what you did with the other three years.
But after 2009, it is looking at not only the two-year residency, but also for the other three years, was it qualified use?
So, for example, renting your home out is not qualified use.
Even if you lived there for two years, if you rented your house out for the other three years, that would be not qualified use. So after 2009, you wouldn’t be able to get an exclusion for those three years.
Now, there’s lots of exceptions around this, and so I just wanted to paint the big picture before we get into the exceptions. I just wanted to make sure you understand that there is basically this concept called non-qualified use that comes onto the scene after 2009.
Exceptions to non-qualified use: last segment
So what are some of the exceptions?
Well, one of the big ones is that the last date the home is used as a primary residence extending to the date the home is sold, that last chunk will not be considered non-qualified use.
That sounds a little complicated, so let me repeat that again.
If you’re using the house as a primary residence, so you’re fulfilling the residency requirement, let’s say you fulfill the two years, then you move out, and then sometime later you sell the house. So you don’t move in at any point once you move out. That last segment when you’re not living in the house is not considered non-qualified use.
That is just a blanket exception the IRS made because the IRS understands it is pretty common to move out of your house into a new house because you bought a new house and then sometime later sell your old house because you’re not always just lucky enough to be able to time the sale and purchase of a home right on the heels of each other.
And so the IRS just made this exception that said, “When you move out, up until the time that you sell, as long as you didn’t move back in, that last chunk will not be considered non-qualified.”
Exceptions to non-qualified use: change in employment, health condition, or unforeseen circumstance
The second area the IRS said is not considered non-qualified (double negative there, I know, a little bit complex) is any temporary absence that doesn’t exceed two years and is due to a change in employment, a health condition, or other unforeseen circumstance.
Very vague. Unforeseen circumstance.
Now we’re going to define what these terms mean (employment, health condition, other unforeseen circumstance) in a moment.
But I just wanted to make sure I highlight that after 2009, there’s this concept of non-qualified use, which is anytime you’re not living in the house.
But there are two exceptions the IRS made.
Exception number one is after you move out, until the time you sell, as long as you didn’t move back in, that last chunk is not considered non-qualified.
And two, any temporary absence two years or less that is due to a change in employment, a health condition, or unforeseen circumstance is also not considered non-qualified.
So, assuming you don’t have one of these two valid exceptions, then what happens if you have non-qualified use?
Basically, you don’t get the full tax exclusion, even if you satisfy the two-year residency requirement.
If you don’t satisfy the two-year residency requirement, you just don’t get the tax exclusion at all.
But if you do satisfy the two-year residency requirement and you have some non-qualified use, then you’re only going to get a partial tax exclusion.
And basically, the way that partial exclusion math is calculated is as a percentage, a fraction, where the denominator is the total number of days you own the home, full stop.
And the numerator is the total number of days that you own the home before 2009 plus only the number of days that you lived in the home starting in 2009.
Everything else is considered non-qualified use, and you don’t get tax exclusion for those days, for that portion, that percentage.
I know that is a little bit mind-bending and maybe hard to follow on a podcast, so let’s just walk through some quick examples to help you get a feel for how this works.
So let’s say you have a married couple. They’ve bought a home for a million dollars. They sell it for $1.6 million.
So there’s $600,000 in gain, $500,000 of which potentially they might be able to exclude from taxes, and then $100,000 of which there’s no chance. They’re going to have to pay taxes no matter what.
And let’s say they lived there in the home as their primary residence for two years, and then they move out and they rent the house out for three years, and they sell exactly five years after they buy the house.
So what are the tax consequences in this scenario?
They’re going to get the full tax exclusion of $500,000.
One, they met the two-year residency requirement because they actually lived in the house for two years.
Two, they fall within the valid exception to non-qualified use because, again, remember, the period after you move out of the home up until the day you sell, as long as you don’t move back in, is not considered non-qualified use.
In this example, they rented the home out for three years, then they sold it exactly at the five-year mark.
So they satisfy the two-year residency rule, and their three-year chunk, that last chunk, doesn’t get counted as non-qualified.
So they get the full half million-dollar gain and then they just pay taxes on the last $100,000.
All right. Let’s do a little twist.
Second example is you have basically the same facts here.
So you have a married couple. They buy the house for a million dollars. They sell it for $1.6 million.
But this time, they live in the house not quite two years, and then they move out, they rent the house out for the remainder of the time, and then again, they sell it exactly at the five-year mark.
So here, they failed the two-year residency requirement.
And even though the period after they moved out is validly an exception from the non-qualified use constraint because they didn’t move back in, they just rented it out for a little bit more than three years, they won’t be able to claim any of the tax exclusion because even though they do fall within that valid exception to non-qualified use, they didn’t pass the first test, which is the two-year residency requirement.
So again, you need both of those things to get the full exclusion.
So in the second example, they’re going to have to pay capital gains taxes on the full $600,000 of gain on their sale.
So let’s dive into another example that’s a little bit more complicated.
Let’s say our married couple again buys their home for a million dollars and then sells it for $1.6 million.
But what happens is once they buy it, they move in, live there for exactly one year, then one of the spouses gets a one-year job rotation to some other place with their company.
And then while they’re away, they rent out the house for one year.
Then after one year of being away, they move back in and then live there two more years. So now we’re a total of four years.
Then they move out again, rent the house out for two more years.
So they’ve owned the home now for a total of six years and they sell right at the six-year mark.
So here we have four discrete usage periods.
Number one, they move in for one year where they’re living there as a primary residence.
Number two, they move out for a job rotation for one year.
Number three, they move back in. This time, they live there for two full years.
Number four, they move out again, rent it out for two years, and then they sell.
So in this situation, what are the tax consequences?
Here, they’re still going to get the full tax exclusion of $500,000 because, first, the IRS is going to look back five years from the date of sale to evaluate the two-year residency requirement.
And in this case, it was satisfied because they lived there when they moved back from their job rotation. They lived there for two years, so that satisfies the residency requirement.
The next thing the IRS is going to do is to determine whether there’s any non-qualified use, namely anytime that the spouses were not living in the house.
And here, there were. There was one year where they were out on a job rotation, and then two years after they moved out the second time where they were renting the house out.
And each of those is going to have a valid exception.
The first year when they were out on the job rotation is going to be a valid exception because they moved due to a change in employment.
And the second period when they moved out and they rented the house out is also going to be a valid exception because it is the last time they moved out. They didn’t move back in and they just sold the house.
Remember, that last chunk is considered is not considered non-qualified use.
So because both of those fall within valid exceptions, they’re still going to be able to take the full $500,000 capital gains exclusion because they met the two-year residency requirement.
I know it’s a little bit confusing, but I wanted to run through some examples so you could get a feel for how the rule is actually applied
Change in employment, health, or unforeseen circumstance
I mentioned a moment ago that there is an exception to the non-qualified use that the IRS grants you if you could not live in the home, if there was a temporary absence not more than two years due to a change in employment, health, or unforeseen circumstances.
I wanted to talk about what qualifies as a change in employment, health, or unforeseen circumstances.
The IRS has published some helpful regulations and examples, so let’s take a look at what those are.
The first thing is for each of these three areas, employment, health, and unforeseen circumstances, there is what’s known as a safe harbor where the IRS, by default, automatically gives you the exception if you qualify for the safe harbor.
And the safe harbor is basically a little test that you use to analyze your situation.
If you pass that test, the IRS will just automatically grant you the valid exception.
If you fail the safe harbor test, it doesn’t mean that you lose the exception. It just means the IRS doesn’t automatically grant it to you. You may have to show more evidence or prove more.
But you’re not automatically denied. You’re just not automatically granted right away.
Change in employment
For change in unemployment, the safe harbor is 50 miles.
Specifically, if your temporary absence is due to a job change where your new job location is at least 50 miles farther from your house compared to your old job location, then by default, you will qualify for the safe harbor and it won’t be considered non-qualified use.
If you didn’t have an old job, i.e., you were working at home, then your new job location just has to be 50 miles or more away from your house.
And importantly, that job change must have occurred when you actually owned the home and were using the home as your primary residence.
In other words, the job change has to be the motivating reason for why you had a temporary absence in the first place.
It doesn’t matter if it’s a new job or a continuation of an old job or they just relocated you. The only thing that matters is the location and the change in your commute distance.
So that’s the exception for the change in job location.
Change in health
Now, what about changes in health?
Changes in health will qualify for an exception basically if anybody in your family who is living at the home has an actual illness or injury, and on a physician’s recommendation, you stop living in the home.
Maybe because you want to be close to the hospital for treatment, for example.
If those conditions are true, it’s somebody in your family who is living in the home who has an actual illness or injury, as diagnosed by a physician, and for that reason, you have to temporarily not live in the home, then that will qualify for the safe harbor for changes in health circumstances.
It can’t just be that moving out of your house is beneficial for your health and wellbeing. That’s not going to qualify for the non-qualified use. It has to be an actual illness or injury.
The third exception around unforeseen circumstances also has a safe harbor that kicks in anytime there is a natural or manmade disaster, death of either yourself or a family member, a job loss that makes you eligible for unemployment benefits, a change in employment status that makes you unable to afford living in your house, divorce or legal separation, multiple births resulting from the same pregnancy.
There’s a laundry list of things the IRS will consider to automatically qualify for the safe harbor.
Now, if you don’t fit into one of the things on that list, it doesn’t mean that you cannot get the unforeseen circumstances exception.
It just means that the IRS may ask for more evidence and it will be more of a case by case determination rather than an automatic default granting of it using the safe harbor.
So those are the main exceptions to the non-qualified use requirement: the change in employment status, change in health, and unforeseen circumstances.
And each of them have a safe harbor provision that will automatically grant you the exception.
But again, not qualifying for the safe harbor doesn’t knock you out of consideration either. It just may mean you have to present more evidence for the IRS to review on a case by case basis.
So that’s pretty much the big picture I wanted to cover for the home sale capital gains tax exclusion.
There are lots of nuances to be aware of for really understanding how the home sale capital gains exclusion works.
So if you want a really fine-grained understanding of those details and all the nuances, I definitely encourage you to check out the blog post that I wrote on this topic, which I will link to in the show notes.
That blog post also contains a lot of narrative examples that tweak little facts in each example bit by bit, so you can see exactly how the tax consequences change when you change slight facts.
And that will really give you a better sense for how the tax exclusion works. You can then apply it and think about how it might work in your scenario, depending on what your situation is.
So if you want the full, fine-grained understanding of how this area of tax works, then be sure you check out that blog post because it’s going to be the most efficient way to really absorb this material.
But for this episode, I just wanted to cover the big picture, high level concepts so you understand what the home sale capital gains exclusion does and the basic rules for how it works.
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Related: be sure to also check out our detailed post with numerous examples and walkthroughs on: How to avoid capital gains taxes when selling your house!