Know When the Gain from a Home Sale is Tax Free

Many retirees sell their residences at least once during retirement. But often, they wait too long to consider whether their gains might be taxed.

Timing matters a lot in determining taxes on the gain of a home sale. Retirees often lose important tax breaks with poor timing of the sale of their old homes and the establishment of a new residence. Some people lose tax-free gains because of the timing of home sales and their moves into assisted living or other senior residences.

The tax rules for selling a personal residence seem to generate more widespread misunderstanding than most other parts of the tax code, though the rules are simple as tax code provisions go.

One problem is that many people still don’t realize the rules were overhauled in 1997. Another problem is that an early version of the Tax Cuts and Jobs Act (TCJA) in 2017 would have overhauled the rules again, and it received a lot of publicity. The proposal didn’t become law, but it continues to surface on the Internet.

Following the 1997 law, the amount of gain you exclude from income has no relation to the amount you roll over or reinvest in another home. In fact, there’s no requirement that you use the proceeds to buy another home to exclude the gain.

Also, age no longer determines the amount of tax-free gain. Gone is the old rule that gave extra tax-free gains to taxpayers ages 55 and over.

Under the current rules, when a taxpayer sells a primary residence, he or she can exclude the first $250,000 of gain from gross income. Married couples filing jointly can exclude the first $500,000 of gain.

Any gain exceeding the exclusion amount is taxable capital gain. (Losses aren’t deductible, because a residence is a personal use asset, not an investment or business asset.)

The number of home sales and the amount of gain that can be excluded from income during your lifetime are unlimited.

There are a couple of rules designed to prevent speculators from earning tax-free gains through home flipping. Sometimes the rules trap other homeowners.

To exclude gain, you must have both owned and used the home as a primary residence for at least two of the five years immediately preceding the sale. The ownership and residence periods don’t have to be concurrent and don’t have to be the two years immediately preceding the sale. That gives some flexibility to people who move out of a home but don’t sell it for a few years.

For example, it allows someone to move into an assisted living or similar residence for a period while recovering from an illness or injury and then move back into their homes without jeopardizing the potential for a tax-free sale.

But someone who moves out of their principal residence and waits too long to sell it loses the potential for a tax-free gain.

The exclusion also can be used only every two years. When a home is sold for a gain before two years have passed since the last home sale at a gain, the amount of gain you can exclude from the second sale is prorated, based on how much time has passed since the exclusion was last used.

For married couples, gain up to $500,000 is tax free even if only one spouse was the home’s owner, if both spouses lived in the home as a primary residence for at least two of the five years. Otherwise, only $250,000 of gain is tax free.

The exclusion applies only to your primary residence. It doesn’t apply to sales of second homes, vacation homes, or rental properties. Gains on sales of secondary residences are subject to capital gains taxes.

Here’s a strategy that works for owners of two or more homes who wish to sell both over time and maximize the excluded gain.

First, sell your primary residence and exclude the gain from income. Then, move into the second home and establish that as your primary residence for at least two years. At that point, you can sell the second home and exclude that gain up to the limit.

The gain from a sale is tax free regardless of what you do with the money. You can buy a less expensive home by downsizing or moving to an area with lower housing prices, and then add the rest of the sale proceeds to your retirement funds.

When a spouse dies, the surviving spouse has two years to sell the home and take the $500,000 exclusion, provided they met the two-year ownership and residence requirements at the time of the first spouse’s passing. If the house isn’t sold within two years of the first spouse’s passing, then the exclusion amount is reduced to $250,000 for the surviving spouse.

The gain from the sale of a home is computed by deducting your tax basis in the home from the amount realized from the sale. The basis includes the cost of improvements to the home as well as the original cost. So, don’t forget to add the cost of any improvements you made to the basis before computing the amount of your gain.