Homeowners who sell their primary residence can exclude up to $250,000 (or up to $500,000 for married couples filing jointly) in capital gains from their taxes. The amount of gain that will qualify for the exclusion is limited based on the amount of time that the house is used as a primary residence. If the house is used other than as a primary residence, capital gains must be allocated between qualifying and non-qualifying use. Any non-qualifying use can potentially reduce the amount of capital gain that can be excluded. The allocation rules take effect beginning January 1, 2009.
Qualifying Use vs. Non-Qualifying UseTaxpayers can qualify to exclude up to $250,000 in capital gains ($500,000 if married and filing jointly) when selling a house. To qualify, the person needs to own and live in the property has his or her primary residence for at least two years out of the five years ending on the date of sale.
Sometimes, however, the property isn't used as a primary residence during the entire five-year period. The house might be rented out, used as a vacation home, or used as a second home. Such uses of the home will be considered non-qualifying use and could subject gains from the sale of the house to tax.
Qualifying use means the property is being used by the homeowner or the homeowner's spouse as a primary residence. Non-qualifying use means the property is not being used as a primary residence by either the homeowner or the homeowner's spouse.
Homeowners who have used the property exclusively as their primary residence (that is, no second homes or rental use) will not need to allocate their gain.
Calculating Excluded and Non-Excluded Gain on the Sale of a HomeGain from the sale of a home may need to be allocated between what gain be excluded and what gain is not excluded. The portion of capital gains that cannot be excluded is determined by the following ratio:
Period of non-qualifying use
Period of ownership
Time Period of Non-Qualifying UseFor the purpose of calculating capital gains, the period of non-qualifying use is any period of time the property is not being used as a main home that begins on or after January 1, 2009. Non-qualifying use prior to January 1, 2009, is disregarded for the the purpose of determining the capital gain allocation.
Temporary absences not exceeding a total of two years in aggregate will not jeopardize qualifying use. A property can maintain its status as a primary residence even if the homeowner is absence due to change in employment, health conditions, or other unforeseen circumstances.
Example of a Capital Gain AllocationTony & Melinda buy a condominium in 2009. They already own a house which they use as their primary residence. They let their daughter Rachel live there for the first two years while she attends graduate school. Melinda moves into the condo in 2011 and makes it her primary residence for three years. Tony and Melinda sell the condo in 2014 after owning the property for five years. (Although I'm working with whole years to illustrate the allocation, you could also measure the periods in days or months.) During the five years that Tony and Melinda owned the condo, there were two years of non-qualifying use when the property was not Tony and Melinda's primary residence. There were three years of qualifying use when Melinda lived there as her primary residence. The ratio of non-qualifying use is 2 / 5, or 40%. Forty percent of the gain will be taxable capital gains, and the remaining 60% can be excluded from capital gains, up to the exclusion limit of $250,000 (or $500,000 for married couples filing a joint return).
Planning Tips for Non-Qualifying UseIn the past, tax professionals advised clients to sell real estate after living in their house for at least two years out of five years ending on the date of sale. This helped clients qualify for the capital gains exclusion because the exclusion was based on the last five years of ownership.
Now, however, the exclusion is based on the period of time when the property is used as a primary residence. Any other use will not be excluded and could trigger capital gains tax.
Taxpayers owning second homes, vacation homes, and rental properties will need to revise their capital gains strategy accordingly. The use test is applied for the time period beginning January 1, 2009, until the property is sold. To get the most tax benefit, the property will need to be used entirely as a primary residence during this time period.
Taxpayers planning to sell a second home may want to move in and make that property their primary residence starting January 1, 2009, to gain as much qualifying use as possible before selling it.
- Section 3092 of Housing Assistance Tax Act of 2008 (H.R. 3221)
- Summary of the tax provisions in H.R. 3221 from the Ways and Means Committee [pdf]
- CCH Tax Briefing on the Housing Assistance Tax Act [pdf]