As mentioned, there are two primary ways to avoid or defer capital gains taxes when buying a new home, one of which is the 121 home sale exclusion. The 121 home sale exclusion, also known as the primary residence exclusion, is a tax benefit that allows homeowners to exclude a portion of the capital gains from the sale of their primary residence from their taxable income. This exclusion reduces the tax burden of selling a home. The 121 home sale exclusion comes with specific restrictions:How Does The 121 Home Sale Exclusion Work?
- Eligibility: To be eligible for the exclusion, you must have owned and used the property as your primary residence for at least 2 of the 5 years preceding the sale.
- Exclusion limits: Under this provision, a taxpayer can exclude up to $250,000 of capital gains on the sale of their primary residence if they’re filing as single or married filing separately. Married couples filing jointly can exclude up to $500,000 of capital gains.
- Frequency of use: You can use this exclusion once every 2 years. Therefore, if you meet the eligibility criteria and haven't used the exclusion in the last 2 years, you can claim it again for a subsequent home sale.
What Kind Of Homes Are Eligible For The Home Sale Exclusion?
Numerous types of homes are eligible for the home sale exclusion, including:
- Mobile homes
- Trailers
- Houseboats
- Condominiums
- Single-family homes
- Cooperative apartments
Remember, property in a retirement community is eligible if the taxpayer receives equity in the property or a co-op if the taxpayer owns stock proportionate to their unit.
Are There Special Exemptions To The Home Sale Exclusion?
Unique circ*mstances sometimes accompany a home sale. Fortunately, you may still qualify for a tax benefit. Specifically, suppose you don't meet the 2-year ownership and use requirement due to specific unforeseen circ*mstances, such as a job change or health problems. In that case, you may be eligible for a partial exclusion based on the time you lived in the property.
Additionally, say you or your spouse are on qualified official extended duty for the U.S. military, the Foreign Service, or the intelligence community. In this case, you can extend the 5-year period for an additional 10 years, allowing yourself a wider timespan to live in the home. Remember, qualified official extended duty means more than 90 days or an indefinite period of service. In addition, you must be living at a duty station at least 50 miles from your primary residence or living in government housing due to government orders.
How Much Can You Save With The Home Sale Exclusion?
The examples below demonstrate how much a homeowner would pay in capital gains taxes in various situations.
Buying A New Home After Selling Current Residence
Here's an example demonstrating how much a married couple filing jointly would pay if their home sale profits exceeded the exclusion limits. Say you and your spouse purchased your home for $400,000. After owning and living in it for the last 30 years, you sell it for $1,200,000. You spent $100,000 on capital improvements while you lived there, meaning your cost basis is $500,000. Therefore, $1,200,000 − $500,000 = $700,000 of capital gains.
Since the capital gain of $700,000 exceeds the $500,000 exclusion limit for a married couple filing jointly, the portion of the gain above the limit ($200,000) will be subject to capital gains tax. In addition, say you and your spouse make $550,000 in 2024. This income level puts you at the 15% long-term capital gains tax rate for married couples filing jointly. So, $700,000 − $500,000 = $200,000 × 0.15 = $30,000. As a result, you would pay $30,000 in capital gains taxes on the portion of the gain exceeding the $500,000 exclusion limit.
In addition, if you and your spouse decide to use the proceeds from the home sale to buy a new home, you can use a portion or all of the sale proceeds as a down payment on the new property. However, the capital gains taxes you owe from the sale of your previous home will detract from your financial capabilities. Specifically, you will have $30,000 less to buy your next home than if you had received an exclusion for all of your capital gains taxes.
Moving Into A Vacation Home Or Investment Property
Using the example above, say you and your spouse sell your home, exceed the exclusion limit by $200,000, and move into your second home instead of buying a new one. This way, while you would still owe $30,000 in capital gains taxes, you wouldn’t worry about applying the profits from the home sale to a new home purchase. In addition, by making your second home your new primary residence, you can use the exclusion rule again in the future, provided you live in the house long enough.
