Money Matters

Sale of a residence can trigger thorny tax questions

September 22, 2012 

Q. We are in a new house, and our old house has been for sale for almost three years and has been rented for the past two years. We had it listed while our current home was being built and then moved into our current home. We have some questions about the capital gain exclusion on home sales.

1) Does the clock start ticking for the two of the last five years when we listed it or when we moved out?

2) Does the fact that we have rented the home for two years impact the amount of our exclusion?

3) If we are running out of time to qualify for the exclusion should we lower the price (as our realtor has suggested on more than one occasion), or will the higher sales price off-set any higher taxes we would owe without the exclusion?

A. First, a refresher on the sale of residence exclusion under IRS section 121. A single homeowner may exclude up to $250,000 of gain, and a married couple may exclude up to $500,000 of gain realized on the sale of a primary residence.

To qualify for the maximum exclusion amounts there are ownership, use and frequency tests that must be met. Individuals qualify for the $250,000 exclusion if they have owned and used the home as a principal residence for at least two out of the five years prior to the sale and they have not sold another principal residence in the two years prior to the sale.

If the residence is owned jointly by individuals and each owner meets these tests, both may exclude a portion of the capital gains up to $250,000 proportional to their ownership in the residence. Married couples qualify for the maximum $500,000 exclusion if they file a joint return, either or both spouses have owned the residence for at least two of the five years prior to the sale, both spouses have used the home as their principal residence for at least two out of the five years prior to the sale and neither spouse has sold a home and used the exclusion in the last two years.

If the exclusion rules are not met, the individual or married seller may qualify for a reduced exclusion.

Under rules that took effect on Jan. 1, 2009, the amount of gain that will qualify for the exclusion is limited based on the amount of time the house is used as a primary residence.

The time the taxpayer owns the home is now divided into qualifying and non-qualifying. Qualifying use is defined as the time 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 the homeowner or spouse. The portion of gains that cannot be excluded is determined by taking the period of non-qualifying use divided by the period of ownership.

Homeowners who have used the property exclusively as their primary residence will not need to worry about allocating their gain on a sale. Periods of non-qualifying use prior to Jan. 1, 2009, are disregarded for purposes of determining the amount of exclusion allowed. Also, periods after the last time the home was used as a principal residence are not counted and do not create a period of non-qualified use.

Finally, answers to your questions:

1) Even though your house was listed for sale, it was still your primary residence until you moved and made your new home your primary residence, so the “clock” didn’t start until that date.

2) Since you rented your home after it was your principal residence, your exclusion will not be reduced as long as you meet the use and ownership test for two out of the five years before the sale.

3) The answer to this question depends on a variety of factors, but the most important is the gain you expect from the sale of your home. If your cost basis is $500,000, and you sell for $1 million within the time to qualify for the exclusion, you owe no capital gains tax. If you hold out and no longer qualify, you will owe $75,000 in capital gains tax this year at 15 percent, and next year the tax is expected to increase to 20 percent, or $100,000.

Meeting with a tax professional to discuss these issues as well as the effect of depreciation recapture is advisable.

Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 99466, Raleigh, NC 27624

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