Anyone that has purchased a home is familiar with the number of financial items that require a buyer’s consideration during closing. Though you won’t have to worry about the endless list of documents that the mortgage underwriter might be demanding, or proving the source of a down payment, there are other things that all homeowners should consider when it comes time to sell. This post is part of a series that is focused on home sellers and will specifically focus on Capital Gains and Tax Savings available to them.

A home is often the largest asset that the average American owns. In fact, as of June 2024, nearly half of homeowners in the United States lived in properties that were considered “equity rich” or had a mortgage balance that was less than 50% of the property’s market value. Often that means they have more than $200k of equity in their home. Whether you have an “equity rich” property or not, if you are selling your home the amount and timing of the sale will have an impact on your taxes at the end of the year.

The good news is that many sellers can benefit from the Section 121 Exclusion. The exclusion in Section 121 gives special tax treatment to the gains from the sale of a primary residence. This treatment allows the seller to exclude the gains from their taxable income. To benefit from a Section 121 exclusion, the seller will need to meet two tests: a use test and an ownership test. Let’s break these down step by step, so you can better understand the tax implications of selling your home and taking advantage of this valuable benefit.

Understanding the Section 121 Exclusion

Sometimes referred to as the Home Sale Exclusion, the Section 121 Exclusion allows qualifying taxpayers to exclude up to:

• $250,000 of capital gains for single filers, or
• $500,000 for married couples filing jointly.

This means that if you meet the criteria, you might not owe any taxes on the profit from the sale of your home.

Qualifying for the Exclusion

To take advantage of the Section 121 Exclusion, you must meet the following tests:

1. Ownership Test
   • You must have owned the home for at least two years out of the last five years.
2. Use Test
   • The home must have been your primary residence for at least two years out of the last five years.
   • The time can be in aggregate, but your use period must amount to at least two years.

In addition to the above tests, you also can not have claimed the Section 121 Exclusion on the sale of another home within the past two years.

What if I Don’t Qualify for the Full Exclusion?

As the saying goes, “Life happens”, and there are a multitude of circumstances that could prevent you from qualifying for the exclusion as its written above. However, the federal government is sometimes sympathetic to these circumstances and does still allow you to take advantage of even a partial exclusion if you sold your home for any of the following reasons:

• A change in employment
• Health reasons such as a chronic illness or a doctor’s recommendation
• Divorce
• Unforeseen circumstances like a natural disaster

These exceptions allow for the seller to partially apply exclusion based on the proportion of time that they met the ownership and use requirements.

Calculating Your Capital Gain

The capital gain is the difference between your basis and the sale price, minus certain expenses, of your home.

1. Determine your home’s basis.
   • Start with what you purchased your home for. The quickest way to capture this is to find the settlement statement provided to you at the time of closing when you purchased your home. From the settlement statement total, you will want to deduct any amounts put into escrow (such as homeowners insurance and property taxes) and any amounts paid to an HOA.
   • To the purchase price, you can then add any costs associated with improvements to the physical structure. This could include, for example, adding a deck to the backyard or replacing the roof.
2. Determine the sale price of the home.
   • For the purposes of calculating the capital gain, the sales price of the home is the price you contracted to sell the house at, minus any real estate commissions, title fees, and legal costs.
3. Subtract your basis from the adjusted sale price.
   • The resulting difference is your capital gain. A negative number would actually be a capital loss. Which also presents, albeit different, tax implications.

If your capital gain is under the exclusion limit, you won’t owe federal taxes on the proceeds from the sale of your house.

Other Important Considerations

• State Taxes: Some states may have their own rules about taxing home sale proceeds, so make sure to check your local tax laws.
• Record Keeping: Keep documentation of your home purchase, improvements, and selling expenses. These records are essential to prove your basis and qualify for the income exclusion.
• Work With a Tax Professional: Tax laws can be complex, and every situation is unique. Consulting with a tax expert ensures that you maximize your benefits and avoid costly mistakes.

Final Thoughts

Selling your home can be a lot of things, but it doesn’t have to be a tax headache. By understanding the Section 121 Exclusion and keeping good records, you can confidently handle the tax implications of your home sale.

If you have any questions or want personalized advice, our team at Edgewater Tax & Accounting is here to help. Contact us to ensure you get the most out of your home sale while staying compliant with tax laws.