For those of us who make our money house flipping, buying up residential properties and renovating them in order to increase their value and sell them off for a profit, it can be galling to go through all that hard work only to have to hand over a chunk of the profits to the internal revenue service in the form of capital gains tax. This is also true for individuals and couples who decide to sell their house after it increases in value organically.
The good news is that with a more in-depth understanding of how the tax system works it is easy to maximize the chunk of the profits that you are able to hang on to after you make the sale. The home sale exclusion is the most effective way of doing this and will be the most suitable option for most people.
Exclusion on The Sale of a Main Home
For unmarried individuals, the home sales exclusion can exclude up to $250,000 from the sale of a main home, for married couples this rises to $500,000. Consequently, if you are single, for example, and you sell your home earning a profit of $150,000, then because this is below the $250,000 threshold you don’t have to report it as taxable income. If, however you secured a profit of $300,000 then you would have to declare the $50,000 as taxable income.
You can use a capital gains calculator to ascertain how much capital gains tax you can expect on a sale.
Sounds too good to be true, right? Well as always there is a catch, the exclusion is not automatic, and you need to understand the different criteria that are in place to assess eligibility.
The 2 out of 5 Year Rule
The 2 out of 5 year rule stipulates that in order to claim home sales exclusion from capital gains tax the seller must have lived in the property in question for a minimum of two out of the last five years, the two years don’t have to be consecutive. This rule precludes most business and rental sales from the home sales exclusion.
If you haven’t quite lived in the property for the required 24 months, then you might still be able to claim the exclusion against a portion of the gains. You may also be able to exclude a portion of your gains if you haven’t lived in the property for the required 24 months owing to a relocation required for work.
Another circumstance in which exceptions to the 2 out of 5 year rule can be made under are when the house is being sold for medical or health reasons. If this is the case, then it is important that you get documentation from a physician as supporting evidence.
The IRS will also potentially allow a partial exclusion in cases where there are other serious unforeseen circumstances that have prevented the homeowner from living the required 24 months in the home.
The home sales exclusion is a very useful mechanism to be aware of if you are planning the sale of a home. Who wouldn’t want to able to keep a bigger slice of the pie from the sale?