If you've been living in your home for awhile, you're probably sitting on a tax gold mine. Under a key tax law provision, a married couple filing jointly can pocket up to $500,000 of home sale gain without owing any federal income taxes if they have owned and used the home as a principal residence for two out the previous five years. Unmarried or married taxpayers filing separately can pocket a gain of up to $250,000 without owing any federal income tax.

There is no limit on the number of times you can exclude the gain on the sale of your principal residence as long as you wait at least two years between sales and meet the ownership and use tests.

More Than One Home?

IRS regulations list several factors that help determine which home is the principal residence. They include: the amount of time the home is used; place of employment; where other family members live; the address used for tax returns, driver's license, voter registration, bills and correspondence; as well as the location of banks, religious organizations and recreational clubs.

Special Tax Break for
Military Personnel

A taxpayer on qualified official extended duty in the U.S. Armed Services or the Foreign Service may suspend for up to ten years of such duty time the running of the five-year ownership-and-use period before the sale of a residence. This applies when the duty station is:
  • At least 50 miles from the residence or 
  • While the person is residing under orders in government housing.

What if you don't meet the two-out-of-five-year rule? Fortunately, you may still qualify for a partial exclusion. IRS regulations make it easy for many people to collect the tax break after "premature" sales of their residences.

The regulations clarify the rules for certain "safe harbors" the IRS has approved. Here's a quick roundup:

  • If you're forced to move due to a job change, you can claim a partial exclusion if your new job is located at least 50 miles farther from the old home than that home was from your old job, or if you can show that the change of employment was the primary reason for the move.
  • You can claim a partial exclusion for "health reasons" if you're selling the home due to treatment of a specific illness or disease and the move is recommended by a physician. The health condition could involve you or a parent, child or other relative. However, the move that causes the premature home sale cannot be done merely to benefit your (or a family member's) general health and well being.
  • The regulations provide a laundry list of unforeseen circumstances that could cause a qualifying premature sale including destruction of a home by a hurricane, divorce or separation, and multiple births from a single pregnancy. The triggering event must be one that you "could not have reasonably anticipated."

How much of the home sale exclusion do you get after an eligible premature sale? You are allowed a percentage of the regular $500,000 or $250,000 limit, depending on how much of the two-year ownership and use test was satisfied.

Let's say you and your spouse own and use a home as your principal residence for 18 months. You are forced to sell because your job is transferred to a distant state. Under these circumstances you would qualify for a reduced gain exclusion of $375,000. This is 75 percent of the full $500,000 joint-filer exclusion, because you owned and lived in the home for 75 percent of the required two-year period.

Bottom Line:
If you qualify for the reduced exclusion, it can be generous enough to completely shelter your profit from federal income tax, depending on the value of your home. The IRS considers the facts and circumstances of each case, but in recent years the tax agency has been lenient in defining "unforeseen circumstances" for this purpose.

For example, in one case, taxpayers who sold their condo after having a child qualified for a reduced gain exclusion. The married couple had a child when they bought the 2-bedroom condo, then later had another baby. The suitability of the condo changed as a result of an "unforeseen circumstance" and was the reason for selling, the IRS found in a private letter ruling. (IRS Private Letter Ruling 201628002)

Of course, a private letter ruling only applies to the taxpayers who requested it. But it's an indication of how the IRS would rule in a similar situation. Consult with your tax advisor if you think you are eligible for a partial exclusion.

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