Capital gain income exclusion on selling your home

The U.S. income tax code is an odd and complicated animal. It’s not only used to generate revenue for the government, but it’s also used to try to encourage (or discourage) certain behaviors. More on that in a bit.

The best way to think about the U.S. tax code is that ALL income is considered taxable, unless it’s specifically carved out from being taxable.

For example, the payout from a life insurance policy is specifically excluded from being taxable. As are gifts received from others. As is a certain amount of gain on selling your primary residence.

Here’s where the part about using the tax code to encourage certain behaviors comes into play… Promoting and fostering home ownership has been a political initiative for many decades. One way to do that is to build into the tax code provisions that benefit homeowners.

For example, there’s a reason why interest paid on mortgages on primary residences is eligible to be tax deductible; to give some incentive to people to buy homes, even if they need a mortgage to do it.

Another part of the tax code that’s preferential to homeowners is the Internal Revenue Code’s (i.e. THE tax code) Section 121, in which it carves out from taxation some or all of the gain on selling one’s primary residence.

Let’s step back first and talk about what a gain is: when you sell something for more than what you paid for it, that’s a gain.

And recall I said that, by default, all income is considered taxable unless it’s specifically excluded form taxation. With that in mind, selling something at a gain is generally taxable, where the amount of the gain is what you’d normally have to pay tax on.

An example would be you bought a stock for $100 and later sold it for $120. Your gain on the sale would be $20. And that gain would be taxable, because that $20 of gain is money or income you didn’t previously have.

In the case of selling your primary residence for a gain, Section 121 of the tax code allows you to exclude up to $250k of gain if you’re single, or up to $500k of gain if you’re married.

There are some conditions that need to be met to qualify for this exclusion. Specifically, you need to have owned and lived in the home as your primary residence for at least two years out of the five years leading up to the date of the sale.

The two years don’t need to be continuous. So long as you can cobble together at least 730 days of ownership and use (as your primary residence) of the property over the five years up to the date of the sale, you meet the eligibility.

For example, assume you’ve owned the property for the last four years. You clearly meet the two-year ownership test.

However, perhaps it’s now your second home that you only visit on occasion as a vacation property, and you haven’t actually lived in it for the last year. BUT, you lived in it for the three years before that. If you were to sell the house now, you’d meet the two-year use test.

There is A LOT more to it than this. Such as what happens if you divorce, your spouse dies, you have to move because of work or health conditions, you are in the military and get sent away on active duty, etc. These life events affect eligibility in various ways.

And what if you’ve rented out the place for a portion of the time you owned it? That also impacts how much you can exclude.

For more information about the various nuances involved, check out episode 71 of the Retirement Planning Education podcast.

And for even more information - straight from the horse’s mouth - check out IRS Publication 523.