One of the greatest tax gifts is the principle residence rules for capital gains on the sale of your home. So great is the principle residence tax exclusion that even married couples filing jointly are benefited to the same, if not greater, extent as single taxpayers. Now, some people may argue that there have been, are and will be greater gifts, but not much beats the simplicity of this rule. The basics of it are immensely easy to grasp: you own a house, you live in it for at least two years, you sell it and you don’t pay any taxes on the gain. Gone are the days when the young homeowner (not wishing to sell and upgrade) had to save every receipt for every upgrade, every repair, every minor item bought at the hardware store. If you have lived in your own home for two years, you probably don’t have to worry.

Of course, there are some technicalities associated with the general rule. They are pretty simple so first I will bullet-point the main ones:

o If you are single your capital gains exclusion is limited to $250,000.00

o If you are married your capital gains exclusion is limited to $500,000.00

o You have to own the home and it has to be your “primary residence” for two of the previous five years

What is your “primary residence”? Basically, it is a home that you personally live in the majority of the year. If you have a house in Palm Beach and one in Lake Tahoe and you spend 8 months of the year at the Tahoe home than that is your primary residence. But, keep in mind the 2 out of 5 part of the rule. Let’s say that the next year you spend 7 months at the Palm Beach house. Then the Palm Beach home is your primary that year. See where I am going with this? You can primary more than one home at once over a five year period so long as each is your main home for at least two years during that five year period. Temporary absences are also counted as periods of use – even if you rent the property during those absences (but talk to your accountant about recapturing any rental depreciation).

Now don’t let the five year requirement confuse you – it only takes two years to achieve the tax exclusion. The five year part is a bonus, allowing you some freedom. You don’t have to personally use the home as your primary residence for two consecutive years or for the two years immediately before you sell, you just have to use it is your primary residence for two of the previous five years. But, it is also a limitation, you cannot live in a house for two years and then rent it for four years and then get the exclusion. You could live in it for two years and then rent it for three years and then sell it (so long as it is sold within the five year mark from when you first lived in it as your primary residence).

Also, bear in mind that married couples do not have to live together. So long as one spouse lives in the primary residence for the two years than the couple can take advantage of the $500,000.00 exclusion. But, they cannot primary two homes at once and get the $500,000.00 exclusion on both. If they live apart during the two year period and each sell their primary then they are each limited to the single taxpayer exclusion of $250,000.00 for each house.

If you have a home office or rental as part of your primary residence or run a business out of a portion of your property, your ability to maximize your capital gains exclusion largely depends upon whether the home office, business or rental was part of your home (in the same dwelling unit) or a separate part of your property (a separate building or apartment). If the business use of your home was contained within your dwelling unit then upon sale you will need to recapture any depreciation taken for that part of the home. But you will not lose any of the allowable capital gains exclusion ($250,000.00 for single taxpayers and $500,000.00 for married filing jointly). If the business use of your home was not a part of your dwelling unit then you need to bifurcate the sale by allocating the basis of the property and the amount realized upon its sale between the business or rental part and the part used as a home. Read the rest of this entry »