Main home

First of all, this tax exclusion applies only to your main home. If you have more than one home, your main home is generally the one in which you live most of the time. Your main home for these purposes can be a house, condomium, cooperative apartment, mobile home, or houseboat. If you own a home, but you live in a different home that you rent, your rented home is considered your main home, and the sale of the home you own would not qualify for the exclusion.

For purposes of determining whether you can exclude the gain on your home, you must first figure the amount of your gain or loss. This is calculated as follows:

1. Selling price
2. Minus selling expenses
3. Equals amount realized on the sale
4. Minus adjusted basis in the home
5. Equals gain or loss on the sale

The following is a brief description of how the selling price is defined, which selling expenses are taken into consideration in determining the amount realized, and some considerations to be taken into account in determining the adjusted basis of the home.

Amount you realized on the sale

To determine whether you had a gain or loss on the sale of your home for tax purposes, you start with the selling price. The selling price includes the money you receive, the fair market value of any property or services you receive, and any mortgage or other debt assumed by the buyer. If you received Form 1099-S, Proceeds From Real Estate Transactions, the total amount you received should be shown as gross proceeds in box 2. But this does not include the fair market value of any other property you received.

The selling price should not include any amounts you receive for personal property, such as furniture, that you sell with the home. And, if you sell your home as a result of a job transfer and your employer reimburses you for any loss on the sale of your home, or for selling expenses, the amount you receive from your employer is reported as part of your employee compensation and does not affect the selling price of your home.

Certain selling expenses are subtracted from the selling price to determine the amount realized on the sale. These selling expenses include commissions, advertising fees, legal fees, and loan placement fees or "points". The selling price minus the selling expenses equals the amount realized on the sale for tax purposes.

Adjusted basis of your home

Next you need to determine the adjusted basis of your home. Your original basis in your home depends on how you acquired it. If you purchased your home, the basis is its cost. If you built it, the basis is the cost of construction. If you acquired your home by inheritance or gift, the basis is either the fair market value of the home when you got it, or the adjusted basis for the person from whom you received the home. While you owned the home, you may have made additions or improvements that are treated as increases in your basis, or you may have casualty losses, depreciation, if you used part of your home for business purposes, or other items that decrease the basis. These increases and decreases are added to or subtracted from your original basis in arriving at your adjusted basis.

Original cost basis

If you bought your home, your original basis is the amount you paid for the home, including the cash down payment and the principal amount of any mortgage, plus certain settlement costs, including the following:

• Fees for title abstract
• Charges for installing utilities, such as electricity and gas
• Legal fees for title search and for preparing the deed
• Recording fees
• Survey fees
• Transfer taxes
• Owner’s title insurance

If you as the buyer agreed to pay amounts owed by the seller, for example for back taxes or interest, sales commission, or charges for improvements or repairs, you can also include these in your basis.

If you had your house built on land that you own, your basis in the home is the cost of the land plus the costs to build the house, including:

• Labor and materials
• Amounts paid to a contractor
• Architect’s fees
• Building permit
• Utility meter and connection charges

If you built the house yourself, your basis includes all costs to complete it, except the value of your own labor or any labor you did not have to pay for.

Other original basis

If you received your home as a gift, your basis depends on the donor’s adjusted basis in the home at the time of the gift:

• If the donor’s adjusted basis was more than the fair market value, your basis is the donor’s adjusted basis, except if by using that basis your subsequent sale of the home results in a loss. In this case, you would use the fair market value at the time of the gift, and then if your sale results in a gain, you do not have to report either a gain or a loss.
• If you received the home as a gift before 1977, and the donor’s adjusted basis was equal to or less than the fair market value at that time, your basis is the lesser of:
• The donor’s adjusted basis plus any federal gift tax paid, or
• The fair market value at the time of the gift.
• If you received the home after 1976, and the donor’s adjusted basis was equal to or less than the fair market value, you basis is the same as the donor’s basis plus the portion of the federal gift tax that corresponds to the increase in the home’s value (fair market value minus donor’s adjusted basis).

If you received the home from your spouse, or from your former spouse as part of a divorce settelement, your basis depends on the date the home was transferred to you.

• If the transfer was made after July 18, 1984, your basis is the same as your spouse’s or former spouse’s adjusted basis at the time of the transfer. This is the case even if you made a cash payment or released certain marital rights.
• If you received the home prior to July 19, 1984, in exchange for your release of marital rights, your basis is the fair market value of the home when you received it.

If you inherited your home, your basis is the fair market value on the date of the decedent’s death, or on the alternate valuation date set by the estate representative. This value is generally listed on the estate tax return. If you are a surviving spouse and owned the home jointly with your deceased spouse, your half of the basis will remain the same as it was (original cost, for example), but the basis of the half interest you inherit from your spouse will be half the fair market value on the date of death or alternate valuation date. You will need to add these two amounts together to determine your new total basis in the home.

Adjustments to original basis

Once you determine your original basis in your home, you may have to add or subtract certain amounts to arrive at your adjusted basis for tax purposes.

Increases in basis

Your basis is increased for permanent additions or improvements you make to your home, special assessments for local improvements, and amounts you spent after a casualty loss in order to restore damaged property.

Improvements are permanent in nature and should be differentiated from repairs, which maintain the condition of your home. For example, painting your home, inside or out, is considered a repair. Improvements add value to your home, prolong its life, or adapt to for new uses. Some examples of improvements include the addition of rooms, a garage, deck, or patio; putting in a driveway, installing a pool, sprinkler system, or landscaping; installing a heating or air conditioning system; putting on a new roof; re-wiring your home; installing carpeting or flooring; and modernizing your kitchen or bathroom.

Special assessments for local improvements may include a sidewalk, for instance, and amounts you had to spend to restore your home after a casualty loss are permanent in nature, and do not include clean-up expenses.

Decreases in basis

You should decrease your basis for any gain you postponed from the sale of a previous home before May 7, 1997, deductible casualty losses and insurance reimbursements, payments you received for an easement or right-of-way, and any depreciation you claimed as a deduction if you used part of your home for business purposes.

There is a worksheet in IRS Publication 523, Selling Your Home, that will help you calculate the adjusted basis.

Tests to qualify for the exclusion

In order to qualify for the exclusion of gain on the sale of your home, you have to meet what are called the ownership and use tests. These basically mean that you must have owned and lived in the home as your main home for at least 2 years during the 5-year period prior to the date of sale. Also, you cannot have excluded gain on the sale of another home within the 2-year period prior to the date of sale of your current home. In other words, you cannot claim an exclusion twice within the same 2-year period.

If you owned the home jointly with another person, each of you can claim an exclusion of up to $250,000 of gain on the sale, provided you meet the tests. If you are married and file jointly, you can claim an exclusion of up to $500,000, provided that either or both spouses meet the ownership test, both spouses meet the use test, and neither of you has excluded gain on the sale of another home in the 2 years before this sale. If you are married filing separately, each of you will have to figure your own portion of the gain or loss according to your ownership interest, as determined by state law. For example, in community property states, you would each normally own 50% of the home.

The 2 years of ownership and use during the 5-year period do not have to be continuous, and the periods of ownership and use do not necessarily have to coincide. For example, while you own the home you may live somewhere else during part of the 5-year period. As long as you meet the total 2-year requirement for both ownership and use at some time during the 5-year period, you will qualify for the exclusion. Temporary absences from your home, during vacations for example, are considered periods of use, even if you rent out your home while you are absent.

Exceptions

There are some exceptions to the ownership and use tests.

• Members of the uniformed services or Foreign Service of the United States can choose to have the 5-year period for the ownership and use tests suspended during any period in which they are serving on qualified official extended duty.
• Persons with a physical or mental disability must meet the 2-year ownership test, but they can qualify for the exclusion if they meet a 1-year use test.
• If your previous home was damaged and condemned, you can add the time you lived in that home to the time you lived in the home you are selling in order to meet the ownership and use tests.

There are other cases in which you may be eligible for a reduced maximum exclusion if you did not meet the ownership and use tests:

• You sold your home due to a change in employment, and your new place of employment is at least 50 miles farther from your home than your former place of employment.
• The primary reason you sold your home was for health reasons. The health reasons can pertain to you, your spouse, a co-owner of the home, a member of your household, or a relative.
• Unforeseen circumstances, which include involuntary conversion; natural or man-made disasters; death, unemployment, or a change in employment or self-employment that leaves you unable to pay basic living expenses; divorce or legal separation; and multiple births.

Assuming you have not claimed an exclusion for a sale of another home during the past two years, the maximum exclusion ($250,000 or $500,000 if married filing jointly) is prorrated based on the lesser of the number of days you actually owned the home during the past five years, or the number of days you used the home.

How to report the exclusion on your tax return

If you have a gain on the sale of your home, you qualify to exclude the gain, and your gain does not exceed the maximum exclusion amount, you do not need to report the sale on your tax return.

If you do not qualify for the exclusion, your gain on the sale is taxable. Or, if your gain exceeds the maximum exclusion amount, the excess amount is taxable. You report any taxable gain on Schedule D, Capital Gains and Losses. You report the entire gain either in Part I of Schedule D as a short-term capital gain if you owned your home one year or less, or in Part II as a long-term capital gain if you owned it for over one year. If you qualify for an exclusion, you should write “Section 121 exclusion” directly below the line on which you report your gain, and show the exclusion amount in parentheses.

A loss on the sale of your main home cannot be deducted.