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Double Your Tax-Free Home Sales

(posted: November 28th, 2016)

There's no limit to how often you can use the federal income tax exclusion for gain from selling a principal residence.

In fact, if you currently own two homes, say, your principal residence and a vacation home, you can "double up" on the exclusion before you downsize for good.

Strategy:
Sell your principal residence and claim the home sale exclusion. Then move into your vacation home full time. After just two years, you can sell the place and pocket more tax-free cash.

Here's the whole story:
If you've owned and used a home as your principal residence for at least two years during the five-year period ending on the sale date, you can elect to exclude from tax the first $250,000 of gain on a sale for single filers or $500,000 for joint filers. This tax break also covers the sale of a home that was a vacation home and converted into a principal residence.

However, for sales occurring after 2008, the portion of gain attributable to non qualified use doesn't qualify for the gain exclusion. The IRS defines "non qualified use" as any use that isn't use as a principal residence.

Therefore, if you're currently using a second home as a personal getaway or rental property, part of your gain from a subsequent sale won't be eligible for the home sale exclusion. The taxable portion is taxed under the usual rules for capital gains. If you owned the home for more than a year, any gain is taxed at a maximum rate of 15% (20% if you're in the top ordinary income tax bracket of 39.6%). However, gain attributable to depreciation on a property that you've used as a rental can be taxed at a maximum federal rate of 25%.

To determine the taxable amount of a gain, divide the amount of time the home was used for non qualified purposes by the total length of time of ownership.

Example

You and your spouse bought the home where you raised your kids decades ago for $250,000. In addition, you acquired a vacation home on Jan. 1, 2013, for $600,000. On Jan. 1, 2015, you sold the main home for $1 million ($750,000 gain) and moved to the vacation home as your principal residence. Then you started to look around for a place to relocate permanently.

Suppose you wait until Jan. 1, 2017, to sell your vacation home (now your principal residence) for $800,000. For simplicity, we'll assume you're in the top 39.6% federal income tax bracket. Let's see what you've accomplished.

  • Home sale #1
    You meet the two-out-of-five-year rule and exclude from tax the maximum $500,000. The remaining $250,000 of gain ($750,000 - $500,000) is taxed at the 20% rate for a tax hit of $50,000 (you may owe state income tax, too).
  • Home sale #2
    You meet the two-out-of-five-year rule, but your non qualified use counts against you. Nevertheless, 50% of the time you owned the home is qualified use (two years [2015 and 2016] out of four years). So you can exclude from tax $100,000 of the $200,000 gain. The remaining $100,000 is taxed at the 20% rate for a tax hit of $20,000.

After two home sales, you've received a total of $1.8 million of sales proceeds ($1 million + $800,000) and realized a combined gain of $950,000 ($750,000 + $200,000). On the $950,000 of gain, you'll pay federal income tax of just $70,000 ($50,000 + $20,000) on $350,000 of taxable gain ($250,000 + $100,000). The other $600,000 ($500,000 + $100,000) is tax free!

Other tax factors, including the 3.8% surtax on net investment income, may come into play.

Questions? Contact us we're here to help.

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