Real Estate: Reducing Taxes on Home Sales

“Real Estate: Reducing Taxes on Home Sales”



In last week’s column, I discussed how to avoid paying capital gains taxes on the sale of various real estate investments.  As you are probably aware, real estate prices have risen sharply in most parts of the country.  Residential real estate is no exception and homeowners have felt the boom of a strong real estate market over the past decade.  However, according to, the rules on taxation of the sale of a residence are quite different than other real estate transactions.  The Clinton Administration made significant tax law changes related to home sales with the passage of the Taxpayer Relief Act of 1997.  Here’s a recap of the rules:


Single tax filers can exclude up to $250,000 of the gain on the sale or exchange of a residence as long as the taxpayer has owned the home and used it as the primary residence for two of the past five years.  Couples filing a joint tax return can exclude up to $500,000 of gain on the sale or exchange of their residence.  To qualify, the home must have been owned by one or both spouses and used by both spouses as the primary residence for two of the last five years.  Further, if one of the spouses has sold or exchanged a primary residence during the past two years, the couple will only qualify for a $250,000 exclusion until that spouse has met the new two-year requirement. 


Under certain hardship circumstances, homeowners may be eligible for partial exclusion of gains.  These hardship circumstances include:

·        Change of employment.  If the principal reason for the sale is due to a change of employment that requires you to move at least 50 miles away from your present location, you will qualify for a partial exclusion.

·        Health reasons.  Here, the principal reason test is met if you must sell your home to obtain, provide, or facilitate the diagnosis, mitigation, cure or treatment of a disease, injury or illness.

·        Unforeseen circumstances.  Hurricane Katrina is an example of an unforeseen circumstance (natural disaster).  Others would include death, divorce or legal separation, involuntary conversion of your home (eminent domain), acts of terrorism, change of employment that results in the homeowner being unable to afford the home, and unemployment that results in the homeowner becoming eligible for unemployment compensation.

·        Other tests.  If you don’t qualify for a partial exclusion based on one of the three safe harbor circumstances mentioned above, the IRS would consider other circumstances on a case-by-case basis.

The amount of partial exclusion is a fraction based on the shortest of the number of days (or months) of ownership or use of the residence or the number of days (or months) since the last sale or exchange, divided by 730 days (or 24 months). 


While these rules seem somewhat complicated, they are actually a vast improvement over the prior law governing the gain on the sale of one’s residence.  You must still maintain accurate records of what you paid for your home and all capital improvements.  From an investment strategy perspective, it’s worthwhile noting that you can extract up to $250,000 ($500,000 for joint filers) of tax-free profits every two years and use the funds for other investment (or non-investment) purposes.  This is a perfect strategy if you’re considering downsizing your living quarters or like to find fixer-uppers and add value through home renovation.