The term “Capital Gain” means the profit on an asset. If you own a house, that is an asset. When selling a house, the profit is determined by subtracting the following, from the selling price:
- Costs of Sale: i.e. brokers commission, attorneys fees, expenses to fix up for the sale;
- Costs of major improvements such as adding new rooms, major renoveation of a bathroom or kitchen, adding a deck, etc. It does not include repairs.
- Cost of Purchase;
- Original purchase price (or in certain cases adjusted basis from a previous rollover)
Any Depreciation that was taken on previous tax returns must be added back.
The IRS allows an exclusion (i.e. an escape from being taxed) on certain sales of a principal residence.
The exclusion applies to to a profit of as much as $250,000 for those filing single .returns or to married couples filing separate returns. and the amount doubles to $500,000 for couples filing joint returns. To qualify, sellers must pass two tests known as the Ownership Test and the Use Test. To be able to claim the exclusion, you must for the 5-year period ending on the date of the sale meet the requirement of the Ownership and Use Tests.:
- Ownership Test: Owned the home for at least 2 years (joint ownership is OK); and:
- Use Test: Lived in the home as your main home for a minimum of 2 years (Temporary absences such as summer vacations count towards periods of use, but not longer ones such as a one-year sabbatical.).
If you qualify under the Use and Ownership test, it does not matter if you are married, separated or divorced. The house does not have to be your principal residence at the time of sale so long as the two tests are met.
The Military Relief Act of 2003 allows for the suspension of the 5-year period during which the two year use and occupancy requirements must be met. A person in the military or Foreign Service may elect to suspend these requirement for a maximum of 10 years while serving at a location at least 50 miles from the principal residence or while living in Government quarters under orders.
NOTE: Certain sellers who do not meet the Ownership and Use tests may still qualify for a reduced exclusion, provided the primary reason for the sale is health problems, change in place of employment, or certain unforeseen circumstances. All of the IRS Rules that apply, including examples, can be found in IRS Publication # 523, which can be downloaded from the IRS website (IRS.GOV) , or mailed pursuant to a request to the IRS.