Tax Rules on Sales of Personal Residences

The Taxpayer Relief Act of 1997 brought sweeping changes to the tax rules applicable to the sale of a personal residence.

In A Nutshell, Effective For Sales After May 6, 1997, The Rules Are -

• $250,000 tax-free gain ($500,000 for married, joint-filing couples).
• 1st Two-Year Rule – Must live in residence for any two out of prior five years.
• 2nd Two-Year Rule – A second home sale within a two-year period is not eligible for this exclusion. Taxpayers can only use this exclusion once in any two-year period.

Exceptions

• Any depreciation of any kind taken on the property after May 6, 1997 remains taxable at a 25% maximum tax rate (rental, home office, etc.).
• A residence which was originally acquired as Replacement Property in a 1031 Exchange must be owned for five years as well as lived in for two out of those five years to qualify (American Jobs Creation Act of 2004).
• Non-Qualified Use after January 1, 2009 during which the residence was not used as a primary residence does not qualify as gain eligible for the exclusion. Gain on the sale of a residence which has non-qualified use after January 1, 2009 has to be prorated between qualifying and non-qualifying gain. The fraction which is non-qualifying is the number of months after January 1, 2009 during which the residence was not the taxpayer's principal residence divided by the number of months of ownership of the residence since it was originally purchased (Housing Act of 2008). See an expanded discussion of this rule below.

A prorata exclusion is available for taxpayers on sales which are less than two years apart, or for failure to meet either of the two-year rules due to change of employment, health or other reasons specified by Treasury Regulations. For instance, one year of residence or second sale after one year = 50% of the above referenced exclusion if the sale was due to qualifying circumstances.