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How is gain from the sale of my home taxed?

UPDATED: February 5, 2019

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Taxpayers can exclude $250,000, or $500,000 for married taxpayers filing a joint tax return, as gain from the sale of a home. This exclusion can be used only once every two years. The home must have been their principal residence for two of the last five years, or they must have a legally valid reason for owning the home less than two years. Legally valid reasons can include divorce, job transfers, death of a spouse, or other non-voluntary reasons. Gain in excess of the exclusion amount is taxed as capital gains, with the most normal rate being 15%.

This deduction can only be used on a primary residence. The IRS defines a primary residence as a residence that you lived in for at least two years over the course of a five-year period. Included in determining where you "lived" is where you are registered to vote, where your car is registered, and your significant ties to the community. Therefore, it is rate to be able to claim a second home as a primary residence, even if you live in both homes fairly equally. However, it is possible to own two homes, and be able to sell both of them within a few years apart, and claim both as your primary residence.

Example 

John and Jane Smith live in Ohio from April 1st to October 1st every year, and live in Arizona from October 2nd to March 31st. They live in both homes for 6 months of the year but they are registered to vote and have their cars registered in Ohio so their home in Ohio is their primary residence. John and Jane are finding it costly to maintain both homes, and have decided that they want to remain permanently in Arizona, but want to downsize to something smaller there.

John and Jane can sell their primary residence in Ohio, and exclude $500,000 of capital gain from tax.  They can then live in their current Arizona home for 2 more years, and be eligible to sell that home and again exclude $500,000 of capital gain.

The "exclusion" is meant as a buffer for long-term homeowners who have a large increase in the value of their homes. Of course, if a taxpayer loses money on the sale of their home, even if it gained them cash, the exclusion would not apply because there would be no capital gain.

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