Selling your home: the exclusion and the 1099-S

If the house was your main home for long enough, a large part of the gain is excluded from income, and most sellers owe nothing. The tests are simple to state and easy to fail by a few months.

What the exclusion is worth

A capital gain from the sale of your main home may qualify to be excluded from income up to $250,000, or up to $500,000 on a joint return with your spouse.

Read those amounts carefully, because the word doing the work is gain. What is excluded is the profit on the sale — roughly the price you sold for, less selling costs, less what the house cost you — and not the money that changes hands at closing. A house sold for well above the joint figure can still produce no taxable gain at all, and a modest house bought decades ago can produce more gain than a large one bought last year.

The two tests

Two tests have to be met, and they are separately failed. The ownership test asks whether you or your spouse owned the home for at least twenty-four months, that is two years, out of the five years ending on the date of the sale. The use test asks whether the home was your residence for at least two of those same five years.

The joint-return twist is the one worth memorizing: either spouse can meet the ownership test, but both spouses must meet the use test individually. The two-year periods do not have to be the same period, so ownership and residence can be counted from different stretches, but both have to fall inside the five-year window ending on the sale date.

Divorce moves both clocks in your favor. Time your former spouse owned the home counts toward your ownership test, and time your spouse or former spouse lived there under a divorce or separation instrument counts toward your use test.

One more rule catches sellers who move often: you are generally not eligible for the exclusion if you excluded gain on the sale of another home during the two years before this sale.

The partial exclusion

Failing the tests is not the end of it. A partial exclusion is available where the main reason for the sale was a change in workplace location, a health issue, or an unforeseeable event, and the amount excluded is then prorated rather than lost.

The work-related reason is the one with a concrete test, and it comes in two shapes. If you already had a work location, the new job — whether you took it or were transferred into it — has to sit at least fifty miles farther from the house than the old one did, both distances measured from the house. If you had no work location at all before, the new job simply has to be at least fifty miles from the house. Either shape counts whether it happened to you, to your spouse, to a co-owner of the home, or to anyone else who was living there as their residence. The health and unforeseeable-event reasons have their own conditions, which Publication 523 defines, and the same publication carries the worksheet that figures the prorated amount.

Basis: what the house cost you

Gain is measured against basis, so the number you need is what the house cost you rather than what you paid the seller. Broadly that is the purchase price plus the costs of buying, plus the improvements you made over the years, reduced by any depreciation claimed while part of the home was used for business or rental. Improvements are not repairs: a new roof is one, patching the old one is not.

This is the reason people keep a folder of receipts for twenty years, and the reason a seller who threw that folder away pays tax on gain that was never really there. Publication 523 has the worksheets for building the number properly.

The 1099-S, and when you must report the sale

Here is the rule people get wrong in both directions. If you receive Form 1099-S, Proceeds From Real Estate Transactions, you must report the sale even if the whole gain is excludable. You must also report the sale if you cannot exclude all of your gain. Reporting and owing are different questions, and a form settles the first one. Where reporting is required, the sale goes on Schedule D, with Form 8949 used to reconcile what was reported to the IRS against what you report, the same machinery described in capital gains basics.

Three special cases sit alongside it. A transfer of the home, or of a share in a jointly owned home, to a spouse or ex-spouse as part of a divorce settlement generally produces no gain or loss and nothing to report from the transfer, which taxes after divorce covers. Members of the uniformed services, the Foreign Service and the intelligence community on qualified official extended duty may elect to suspend the five-year test period for up to ten years. And a loss on a personal residence is not deductible, because losses on personal-use property never are.

What to do before closing

Find the settlement statement from when you bought, total the improvements from the receipts you still have, and ask the closing agent whether a Form 1099-S will be issued for the sale. Then check the calendar against the two-year clock before you sign anything that fixes a closing date, because a sale that lands a few weeks early is the most avoidable tax bill in this article.