Your home may not always be your castle, but if it is your principal residence, there is one very significant tax benefit when you decide to sell.
The Taxpayer Relief Act of 1997 terminated both the rollover and the once-in-a-lifetime exemption, which were the existing tax benefits at that time. In its place, the law substituted a more beneficial approach for American homeowners.
When you sell your home, married couples can exclude from their taxable income up to $500,000 of gain. Individuals filing separate returns can exclude up to $250,000. Unlike a deduction, which allows you to take a percentage off your gross income (based on the tax rate bracket in which you fall) the exclusion means that the profit you make up to the statutory ceiling is not even included in your income for tax purposes.
There are two important conditions:
●You must have owned and used the home as your principal residence for two out of five years before the sale. If you are married, although both husband and wife must meet the “use” test, only one of you must meet the “occupancy” test. Marital status is determined on the date the house is sold. In the event of a divorce when one spouse is given ownership pursuant to a divorce decree or separation agreement, the use requirements will include any time that the former spouse actually owned the property before the transfer to the other spouse.
●The exclusion is generally applicable once every two years. However, if you are unable to meet the two-year ownership and use requirements because of a change in employment, health reasons or unforeseen circumstances, then your exclusion may be prorated.
The Internal Revenue Service has issued regulations that will guide you if you are faced with having to sell before the two years are up. There are what is known as “safe harbors” — in other words, if you fall within the guidelines, you are safe to take the partial exclusion.
These safe harbors include having to sell because you got a new job at least 50 miles farther from your home than your current location, your doctor recommends a change of location for health reasons for the treatment of a disease or you encountered unforeseen circumstances, such as a divorce or natural disaster.
If you are eligible for the partial exclusion — either because you meet the safe harbor tests or get specific approval from the IRS — this exclusion is equal to the number of days of use times the quotient of $500,000 divided by 730 days. Note that 730 days is two full years. If you are single — or do not file a joint tax return — change the $500,000 to $250,000.
This law applies to all principal residences: single-family homes, condominium units and cooperative apartments. If your boat or your mobile home is your principal residence, the law is also applicable if three things are present: sleeping quarters, a toilet and cooking facilities.