I talked with a client last week about something he had overheard in a social situation. He thought it had to do with the need to live in a home for a certain number of years to avoid taxation upon sale – but he wasn’t sure of the specifics. This comment surely dealt with the concept of the capital gains exemption on the sale of a primary residence. Let’s take a closer look.

In its simplest form, a capital gain is the difference between the price you sell an asset for and the price you paid for it (known as the cost basis). Under the current US tax code (federal and state), a separate scale of tax rates apply to capital gains, varying greatly based on the holding period of the asset and income levels. They can range from 0% all the way up to the top marginal tax rate. Capital gains and the related tax are only incurred upon sales of the assets (at least for now!)

For many people, one of the largest assets they will ever own (and likely eventually sell) – is their home. A home is also an asset that may be subject to a considerable amount of appreciation in value, depending upon the holding period, entry price, and geographic region. Given this fact – as well as a desire to promote home ownership in this country – the US federal tax code (and most state tax codes) allows for special capital gains tax treatment related to peoples’ primary homes (referred to as their primary residence). These favorable rules do not apply to second homes, vacation homes, or rental homes – only your primary residence.

How does the IRS define primary residence? There is an ownership and a use test. You need to have both owned and lived in the home for two of the past five years. You can also not have excluded a gain from another home sale in the two-year period preceding the sale. These rules become very important to remember as you approach a potential selling date of your home (especially if it has a large capital gain).

Why? Because the IRS grants a capital gains tax exemption on the sale of your primary residence ($250,000 for single filers, $500,000 for married couples). Any capital gain in excess of that amount will be taxable; however a gain beneath or equal to that will not be subject to capital gains tax. (Note: state income tax rules vary – be sure to review for your given state)

How is the capital gain calculated? The selling price will be fairly straightforward. The cost will require some figuring as you can include not only your initial purchase price but also any money spent over the years to improve its condition, add value/space, or adapt the home for new uses. This does not include money spent on routine repairs but rather items that would be viewed as enhancing the homes value (ex: addition, remodeling work, adding a pool, etc) As a result, it’s a good idea to track these items and keep receipts/payment support over the years. It may just come in handy when/if you do sell! You would then compare the capital gain to your applicable capital gain exemption to see if any taxable gain remains.

These rules are always important to keep in mind – but especially so if you ever find yourself owning two homes. You will want to sync up your primary residency with your sales. As an example – I’ve heard a few stories of Wisconsinites who buy a home in FL and decide to become FL residents (in an effort to save on state income tax). Their Florida home becomes their primary residence (partly to support their tax filing methodology, partly due to time they spend there). Several years later, when they go to sell their Wisconsin home, they are unpleasantly surprised that the full capital gain is taxable since it no longer qualifies as a primary residence. The rules are pretty forgiving and easy to follow – if you know what to look for in advance!