It is true in most cases. When you sell your home, the capital gains on the sale are exempt from capital gains tax. Based on the Taxpayer Relief Act of 1997, if you are single, you will pay no capital gains tax on the first $250,000 you make when you sell your home. Married couples enjoy a $500,000 exemption. There are, however, some restrictions on this exemption.
Sale of Primary Residence
In order for the sale to be exempt, the home must be considered a primary residency based on Internal Revenue Service (IRS) rules. These rules state that you must have occupied the residence for at least two of the last five years.
If you buy a home and a dramatic rise in value causes you to sell it a year later, you would be required to pay capital gains tax on the gain. This rule does, however, allow you to convert a rental property into a primary residence because the two-year residency requirement does not need to be fulfilled in consecutive years. For example, suppose that you invest in a new condo. You live in it for the first year, rent the home for the next three years and, when the tenants move out, you move back in for another year. At the end of this five-year period, you will be able to sell your condo without having to pay capital gains tax.
Capital Gains Tax
The other major restriction is that you can only benefit from this exemption once every two years. Therefore, if you have two homes and lived in both for at least two of the last five years, you won't be able to sell both of them tax-free.
The Taxpayer Relief Act of 1997 has been beneficial for homeowners because it has significantly changed the implications of home sales. Before the act, sellers had to roll the full value of a home sale into another home within two years in order to avoid paying capital gains tax. This, however, is no longer the case, and the proceeds of the sale can be used in any way the seller sees fit.
Kimerly Polak Guerrero, CFP®, RICP®
Polero ICE Advisers, New York, NY
In addition to the $250,000 (or $500,000 for a couple) exemption, you can also subtract your full cost basis in the property from the sales price. Your cost basis is calculated by starting with the price you paid for the home, and then adding purchase expenses (e.g., closing costs, title insurance, and any settlement fees).
To this figure, you can add the cost of any additions and improvements you made that had a useful life of over one year. Finally, add your selling costs, like real estate agent commissions and attorney fees, as well as any transfer taxes you incurred. By the time you finish totaling all these costs of buying and selling and improving the property, your capital gain on the sale will likely be much lower, enough to qualify for the exemption.