Why bypass the home sale exclusion?

QTA Consultants, Ltd./Renata Bliumaite

Sometimes you should pass up a current tax break for a better one later on.

Strategy: Don’t claim the home sale gain exclusion now if you can shelter more profit from tax in a subsequent home sale. As long as you meet the tax law requirements (see box on page 2), you can save the exclusion for when it will do you the most tax good.

Here’s the whole story: You can exclude from federal taxable income up to $250,000 of gain from the sale of your home or up to $500,000 if you’re married and file a joint return. To qualify for this lucrative tax break, you must have owned and used the home as your principal residence for at least two out of the five years ending on the date of sale. Alternatively, if you fail either the use or ownership tests, you still may qualify for a partial exclusion if you’re forced to sell the home due to a change in employment, health reasons or certain other unforeseen circumstances. This is not a onetime opportunity. You can take advantage of the exclusion multiple times during your lifetime. But it can’t be used if you’ve claimed the exclusion for another home within the past two years. If you’re fortunate enough to own two homes, you might bypass the home sale exclusion for a chance at bigger tax savings down the road.

Example: You and your spouse moved into a condo five years ago that cost $600,000. It was your principal residence for the first three years of ownership. But you also own a lake house in a resort area, purchased years ago at the bargain price of $200,000. For the last two years, you’ve lived mostly at the lake house, so it also qualifies as your principal residence.

Earlier this year, you sold the condo for $625,000. You’re also planning to sell the lake house and move permanently to a warmer climate. The real estate market is strong in the resort area, so you figure the lake house will fetch around $700,000 in a sale. You expect your regular income to exceed $500,000.

On these facts, you’re entitled to the home sale exclusion for the condo sold earlier in 2023. If you claim the exclusion for that sale, you won’t have to pay tax on a $25,000 gain. With the maximum 20% long-term capital gains rate, you’d save $5,000 (20% of $25,000).

Better approach: Don’t claim the home sale exclusion for the condo. Instead, pay the tax bill at the long-term capital gains rate. Then, if you sell the lake house for $700,000 later this year, you can claim the maximum $500,000 home sale exclusion. This saves you $100,000 in capital gains tax (20% of $500,000)—or $95,000 more ($100,000 – $5,000).

More angles to the exclusion Here are several special rules relating to the home sale exclusion: • Joint filers: If you file jointly, you can claim the maximum $500,000 exclusion if (1) either spouse meets the ownership test, (2) both spouses meet the use test and (3) neither spouse has claimed the exclusion within the last two years. • Use test: You must physically occupy the home for at least two years. But short, temporary absences won’t count against you. • Principal residence test: If you own and reside in two homes during the year, the place where you stay most of the time is your principal residence. • Depreciation recapture: If you’ve claimed depreciation on a home office, you must recapture deductions attributable to business use after May 6, 1997, at a 25% federal rate.