Capital Gains on a Home Sale: The 2-of-5-Year Exclusion Rules

Do I pay capital gains when I sell my house?

You can exclude gain on selling your main home up to $250,000, or $500,000 for a married couple filing jointly, when the three tests below are met and neither bar below applies (26 U.S.C. 121; Publication 523). Gain is the sale price minus selling costs and your adjusted basis: generally what you paid, plus improvements, minus any depreciation. Upkeep such as painting or fixing leaks is not an improvement.

Two automatic bars apply: a home acquired in a 1031 exchange within the past 5 years, and a seller subject to the expatriate tax (Publication 523). A loss on selling a main home is not deductible. The law sets no age test and does not require buying another home, and the exclusion can be used again once 2 years have passed (26 U.S.C. 121(a) and (b)(3)).

A home sale is not simple when the home was ever rented or used for a business, when you sell before 2 years, when spouses did not both live there, when title is in an LLC or trust, or after a divorce or a death. Those cases can leave part of the gain taxable.

Gather the closing statements from the purchase and the sale, receipts for improvements, the dates you moved in and out, any depreciation you claimed, and any Form 1099-S.

What tax do I pay on gain above the exclusion?

Taxable gain on a home owned more than one year is long-term capital gain, taxed at 0%, 15% or 20% depending on income; gain from depreciation is taxed at up to 25% (Topic 409). Taxable gain can also bring the 3.8% net investment income tax when modified adjusted gross income is above $200,000 ($250,000 joint); excluded gain cannot (IRS).

How is the 2 out of 5 year rule counted?

The 5 years run back from the date of sale, and each 2-year test is met with 24 full months or 730 days, added up in any number of pieces (26 CFR 1.121-1(c)). The date of sale is the date in box 1 of Form 1099-S; without that form, it is the earlier of the day title passed or the day the buyer took on the burdens and benefits of ownership (Publication 523).

• Ownership and use need not overlap. Years you rented the home as a tenant before buying it count toward the use test, if both tests are met within the 5 years (26 CFR 1.121-1(c); Topic 701).
• Short absences count as use. A vacation or seasonal absence counts as time lived there, even if the home was rented meanwhile. A year-long sabbatical abroad does not, in the regulation's own example.
• Care facility time can count. An owner who becomes unable to care for themselves, and lived in the home for at least 12 months of the 5 years, is treated as living there while in a state-licensed care facility such as a nursing home (26 U.S.C. 121(d)(7)).
• A replaced home can count. If an earlier home was destroyed or condemned and you put off that gain by buying this one, time in the earlier home counts (26 U.S.C. 121(d)(5)).
• Some title holders count as you. A grantor trust you are treated as owning, or a single-owner entity disregarded for tax, counts as you (26 CFR 1.121-1(c)(3)). For other entities, see a home in an LLC.

2 out of 5 year rule after renting it out: how much can I still exclude?

Rental after your last day living there, inside the 5-year window, does not cut the exclusion. Rental or other time from January 1, 2009 when neither you nor your spouse or former spouse lived there as a main home does, if it comes before the last day either of you lived there, whether before you moved in or between two stays: that share of the gain stays taxable (26 U.S.C. 121(b)(5)). Sell more than 3 years after moving out and you no longer lived there 2 of the 5 years, so the full exclusion is lost; a partial one needs a work, health or unforeseen reason (below).

The taxable share is the days from January 1, 2009 when neither of you lived there, before the last day either of you did, divided by all days you owned the home (Publication 523, Worksheet 3). Gain equal to depreciation is taken out first and taxed separately.

Depreciation for periods after May 6, 1997 is never excluded, and it counts whether you claimed it or only could have claimed it (26 U.S.C. 121(d)(6); Publication 523). An owner who rented for years without depreciating still has that amount taxed. For depreciation, recapture detail and exchanges, see rental property taxes.

Sold my house before 2 years: is there a partial exclusion?

A seller who misses the 2-year tests, or sells within 2 years of an earlier excluded sale, can still exclude part of the gain when the main reason for the sale is a work move, health, or an unforeseen event (26 U.S.C. 121(c)). The event can happen to you, your spouse, a co-owner, or anyone else who lived in the home as their residence (Publication 523). Each safe harbor needs the job change or event to happen while you own and live in the home.

Outside these safe harbors, the facts must show the event was the main reason. Factors that weigh in favor: it arose while you owned and lived there, could not reasonably have been foreseen when you bought, and came shortly before the sale (26 CFR 1.121-3). Wanting a bigger home, a pay raise, or a rise in the home's value does not qualify, and a move that only helps general health is not a health reason.

The partial limit is the full limit times a fraction: the shortest of your time owned and your time lived there, both within the 5 years, and the time since your last excluded sale, over 24 months or 730 days (26 CFR 1.121-3(g)). On a joint return that misses the joint test, each spouse's amount is worked out this way and added.

Home sale exclusion for married filing jointly: who gets the joint amount?

A married couple filing jointly gets up to $500,000 only when either spouse meets the ownership test, both spouses meet the use test, and neither excluded gain on another home within 2 years (26 U.S.C. 121(b)(2)). Otherwise the couple's limit is the sum of what each spouse would get if unmarried, with each treated as owning the home for as long as either spouse did.

If one spouse is a nonresident alien, a joint return needs a choice to treat that spouse as a US resident; see married to a nonresident.

Rules for spouses who part ways or lose a spouse (26 U.S.C. 121(d); 26 CFR 1.121-4):

• Separated or divorced: an owner whose spouse or former spouse is allowed to live in the home under a divorce or separation instrument is treated as living there too.
• Home received from a spouse or ex-spouse: you count the time they owned it, but must meet the use test yourself.
• Surviving spouse: an unremarried surviving spouse counts the late spouse's ownership and use, and can use the joint limit if the home is sold within 2 years of the death and the joint tests were met just before it.

I own two homes: which one counts as my main home?

A person has only one main home at a time, and only that home qualifies (Publication 523). When you live in two homes, the one you live in most of the year is ordinarily your main home (26 CFR 1.121-1(b)(2)).

Other facts point the same way: the address on your tax returns, driver's license, car and voter registration; where you work, bank and get mail; and where your family lives. A home you switched to in different years can qualify in turn, but the 2-year look-back stops you excluding gain on both within 2 years. Gain on a home that fails the tests is taxable and can count toward net investment income tax.

I live in one unit of a duplex or use part of the home for business: how is the gain split?

The answer turns on whether the business or rental space is inside your living area or a separate unit (26 CFR 1.121-1(e)).

Split the price and basis the same way you split them for depreciation, or by floor area if you never depreciated (Publication 523).

Military or Foreign Service: can the five-year window be stretched?

Yes. A member of the uniformed services or the Foreign Service, an employee of the intelligence community, or a Peace Corps employee or volunteer serving abroad can choose to suspend the 5-year window while they or their spouse are on qualified official extended duty, for up to 10 years (26 U.S.C. 121(d)(9) and (12)).

Qualified official extended duty means orders for more than 90 days or for an indefinite period, at a duty station at least 50 miles from the home, or living in government quarters under government orders (Topic 701). The choice covers one property at a time, can be revoked at any time, and is made by filing the return for the year of sale and excluding the gain (Publication 523).

Used the exclusion in the last two years, or got the home in a 1031 exchange: can I still exclude gain?

Each can block the exclusion. A seller who excluded gain on another home in the 2 years before this sale cannot exclude again, unless a work, health or unforeseen reason allows a partial exclusion (26 U.S.C. 121(b)(3)).

A home acquired in a 1031 exchange cannot use the exclusion if sold within 5 years of that exchange. The same bar applies to someone whose basis comes from the person who made the exchange, such as a child given the home (26 U.S.C. 121(d)(10); Publication 523). See rental property taxes for exchanges.

Home received as a gift, by deed from a relative, or after a spouse died: what basis and which years count?

The basis depends on how the home came to you, and the years that count depend on who gave it (Publication 523).

Publication 523 counts an earlier owner's time only for a spouse, former spouse or late spouse; with a home from a parent or an estate, have the count checked before relying on the earlier owner's years. Adding a child to the title is a gift; see gift tax returns. An heir or executor selling a parent's home should see estate and final returns.

Got a 1099-S for my home sale: do I have to report it?

Yes. A Form 1099-S means the sale goes on Form 8949 and Schedule D even when all the gain is excluded (Topic 701). Without a 1099-S, you report only if part of the gain is taxable, or if you choose to be taxed now and keep the exclusion for a later sale (Publication 523). You can make or undo that choice within 3 years of the return's due date, not counting extensions (26 CFR 1.121-4(g)).

1. On Form 8949, report the sale price and basis as if no exclusion applied, using Part II if you owned the home more than one year.
2. Enter code H in column (f) and the excluded gain as a negative number in column (g). If selling costs are not on the 1099-S, add them to that negative amount and enter code EH (Instructions for Form 8949).
3. Report gain from depreciation, and gain on any separate business or rental part, on Form 4797.
4. A loss with a 1099-S is still reported, with code L, so that it nets to zero (Instructions for Schedule D).

A home bought with a loan from tax-exempt mortgage bonds or with a mortgage credit certificate may owe recapture on Form 8828 even when the gain is excluded. Keep purchase and improvement records until 3 years after the due date of the return for the year of sale (Publication 523).

Example

These examples are illustrative and use US dollars. Selling costs are left out to keep the numbers round.

Rented after moving out

A single owner buys a home for US$300,000 and lives in it for five years. She then moves out and rents it for three years, claiming US$20,000 of depreciation, and sells for US$520,000.

• Years 1 to 5: main home.
• Years 6 to 8: rental; the 5 years before the sale include her last 2 years living there.
• Sale: adjusted basis is US$280,000 (US$300,000 minus US$20,000), so the gain is US$240,000.

The rental came after she moved out, so it does not reduce the exclusion. The US$20,000 equal to depreciation is taxed; the other US$220,000 is under the US$250,000 limit and is excluded.

Job move after 14 months

A single owner whose job is 10 miles from home takes a new job 300 miles away while living there, and sells after owning and living in the home for 14 months, with a US$40,000 gain. The work move meets the 50-mile safe harbor. The partial limit is 14/24 of US$250,000, about US$145,800, so the whole US$40,000 gain is excluded.

Two homes after marriage

Each spouse owned and lived in a home before marrying. They move into hers, and he sells his while he still has 2 of the last 5 years of living there, with a US$180,000 gain. On their joint return, his home's limit is US$250,000, not US$500,000: she never lived there, and moving in together is not a work, health or unforeseen reason, so her share is zero. His US$180,000 gain is fully excluded.

Different for you?

• The home was rented, used for a business, or held in a trust: the split between taxable and excluded gain needs the full worksheets; get individual tax help.
• The gain is above your limit, or you sold after a divorce or a spouse's death: have the limit and basis checked with individual tax help, and plan payments with quarterly estimated tax.
• The property was only ever a rental, or you are doing a 1031 exchange: see rental property taxes.
• The home is held in an LLC: see rental property in an LLC.
• The home is outside the US, or the currency moved: see property abroad.
• You live in Canada and are selling US property: see Canadians selling US real estate.
• You are selling a home in Canada as a Canadian resident: see Canada's principal residence exemption.
• You are selling a parent's home as executor or heir: see estate and final returns.
• The home is in a state where you no longer live: see nonresident state return thresholds.
• You are gifting the home or adding a child to the title: see gift tax returns.