A Brief Guide to Primary Home Exclusion for Capital Gains

Your home is one of your biggest investments, and it’s natural for you to expect a sizeable return if you decide to sell the property. You’ll, however, be expected to file returns on the capital gains that accrue, which can be an anticlimax of sorts. If you’re ready to scan through the law books or are open to hiring the services of an experienced attorney such as the Law Offices of Nick Nemeth, there are more than one ways to save taxes on capital gains, provisioned in Section 121 of the Internal Revenue Code. The blog enumerates some such measures and their qualification pre-conditions.

1. Sale of the Taxpayer’s Primary Residence

The IRS doesn’t tax capital gains of up to $250,000 you may realize from the sale of your primary residence. All you need to do to claim this benefit is fill the Form 1099-S, ‘Proceeds from Real Estate Transactions’ (used to report sales exceeding the exclusion limit) and fulfill the following criteria:

  • The house must be your primary residence, and you can claim a benefit only if you’ve been using the residence for the past couple of years out of the last 5 years before the date of sale
  • The house was not received as an exchange for other property (a like kind exchange) neither as a gift from a person who got the ownership under a like kind arrangement
  • You haven’t claimed the benefit in the past 2 years
  • You are exempt from the expatriate tax

If you’re using an undeveloped land as a part of your residence, you can claim an exemption for both the land as well as the house collectively subject to the condition that you’re selling both the properties within a 2-year period.

Additionally, married couples can claim up to a benefit of $500,000 ($250,000 each)  subject to the following conditions:

  • Both the partners must be filing jointly
  • Either of the partners has been an owner for at least 5 years
  • The house has been a principal residence for at least two years for both the partners
  • Neither of the partners has filed for an exemption within two years from the date of sale of the primary residence

2. Availing Prorated Exclusion

Under normal circumstances, you can claim an exclusion only if you have been living in the primary residence for at least 2 years. There are, however, some exceptions to this rule. You may claim also a benefit on a pro-rata basis. If, for instance, you are an individual taxpayer, have used the house for a year, and need to sell it for any of the reasons “qualified” by the IRS, you’ll be eligible to claim a 50 percent benefit (of up to $125,000). Let’s take a look at the “qualified” reasons.

Change of Employment

You’ll be eligible to file an exemption if your new job location is 50 miles (or more) further than the old one from your primary residence – subject to its condition, at the time of job change. Unemployed taxpayers can also qualify if they secure a job 50 miles away from the residence.

Must Read: 5 Must-Know Facts about Unemployment Benefits

Health Issues

You can file for an exemption if you had to sell the house to relocate to an alternate residence to address your or a close relative’s health issues.

Must Read: Individual Shared Responsibility Provision and Income Tax Return: An Overview

Unforeseen Circumstances

You also gain exemptions in cases of unplanned circumstances, such as damage due to disasters (or death), divorce, legal separation, or a change of employment, which may change your financial condition, therefore making it difficult for you to maintain the house.

3. Using a Part of Your Residence for Business Purposes

The above rules also apply to any part of the house you’ve been using for business purposes. The Revenue Code, however, doesn’t allow any benefits for depreciation the taxpayer may have claimed after May 6, 1997. For example, if you sold your house for $100,000 and reported a depreciation of  $5,000, only $95,000 would qualify for exemption. The taxpayer, in such cases, need to report the depreciation on Form 1040 (Schedule D, Capital Gains and Losses) as an unrecaptured gain, which is a taxable component.

Additionally, if you decide to sell a house you converted into a rental property, the capital gains would be calculated on adjusted tax basis, at the time of sale (if you make a profit). If you end up with a loss, the basis for calculation would be the lower of the property’s adjusted tax basis* and FMV** (fair market value), at the time of conversion.

*adjusted tax basis: The value arrived by deducting depreciation till date from the asset’s value at the time of sale. Suppose you buy a car for $20,000 that has a life of 10 years and a depreciation rate of 10 percent every year. If you decide to sell the car at the end of the sixth year, the adjusted tax basis would be $20,000- $12,000 ($2,000×6)= $8,000 (the amount taxable).

**FMV: The market value of a property or the price that a seller is ready to pay when the property is transferred under fair conditions, that is both the buyer and seller are under no pressure to settle for the said price and ample time has been provided for the transition to take place.

Exemption to Non-qualified Use

If you’re not using the property as your primary residence, it will be termed as “non-qualified use”, and you may not be able to file for exemptions. There are, however, some exceptions to this rule, too.

  • The applicable period (for calculating the capital gains) was before 2009
  • Any period (must not exceed five years prior to the date of sale) from the last date you used the property as your primary residence
  • Failing to use the property as a primary residence for 2 years or less due to illness, change of employment, or unavoidable circumstances
  • Absence of 10 years or less due to extension of official duty as a member of the Armed Forces, Foreign Services, or an intelligence community

Final Words

These are some broad clauses under which taxpayers can avail primary home exclusion for capital gains. To learn more about such measures and ensure you get the maximum possible benefits, speak with one of the IRS tax consultants, at the Law Offices of Nick Nemeth. Our lawyers possess an in-depth understanding of IRS tax laws, garnered through extensive experience in helping clients in diverse IRS taxation related issues and concerns. Simply call (972) 426-2553 or fill out our contact form and we’ll get back to you, shortly.

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