Selling your home can be a bittersweet experience. Although you’re eager to start a new chapter in your life, you may be concerned about the tax ramifications. But worry not—you can save a substantial amount of money on capital gains taxes by utilizing the 2-out-of-5-year rule.
What is the 2-Out-of-5-Year Rule?
If you’re single, you can deduct up to $250,000 in capital gains from the sale of your primary residence; if you’re married filing jointly, you can deduct up to $500,000 in capital gains. You have to have owned and occupied the house for at least two of the five years prior to the sale in order to be eligible. The good news is that you don’t even have to reside there on the day of the sale, nor do these two years have to be consecutive.
Benefits of the 2-Out-of-5-Year Rule:
- Lower your tax bill: This rule can significantly reduce your capital gains tax liability, saving you thousands of dollars.
- Flexibility: You can use this exclusion multiple times, as long as you meet the eligibility requirements each time.
- Applies to various situations: Even if you rented out your home for a period or used it as a vacation rental, you can still qualify for the exclusion as long as you meet the ownership and use tests.
Exceptions to the 2-Out-of-5-Year Rule:
Even if you haven’t lived in your home for two years you might still be able to claim a partial exclusion under certain circumstances, such as:
- Separation or divorce
- Death of a spouse
- Sale of vacant land
- Ownership of a remainder interest
- Destruction or condemnation of the previous home
- Military service during ownership
- 1031 like-kind exchange
How to Calculate the Partial Exclusion:
If you qualify for a partial exclusion, you can calculate the amount by multiplying the number of months you lived in the home by $250,000 (or $500,000 for married couples) and dividing the result by 24.
Remember:
- Consult a tax professional for personalized advice regarding your specific situation.
- Keep detailed records of your ownership and use of the property to support your claim for the exclusion.
- The 2-out-of-5-year rule is a valuable tool for homeowners looking to minimize their tax burden on home sales. By understanding the rule and its exceptions, you can maximize your savings and keep more money in your pocket.
Additional Resources:
- IRS Publication 523: Selling Your Home
- Realized1031: What Is the 2-Out-of-5-Year Rule?
Calculate Your Basis Correctly
Only the profit from the sale of your house—that is, the sale price less your cost basis—is subject to capital gains tax. Make sure to accurately determine your cost basis by factoring in the purchase price, all closing costs (such as real estate agent commissions and title fees), and any significant upgrades you made to the house that will remain useful for longer than a year.
Official Extended Duty
A married couple selling a house may choose to suspend the five-year ownership and use test period for up to ten years if one or both of them are serving on official extended duty in the intelligence community, the Foreign Service, or the uniformed services. In order to qualify for “official extended duty,” a person must be living under government orders in government housing for at least 90 days or serving at a duty station at least 50 miles from their primary residence.