When it comes to selling your home, there’s a lesser-known tax break that might pleasantly surprise you: the “Section 121 exclusion.” This perk allows you to shield a chunk of your home sale profits from capital gains taxes, with limits set at $250,000 for individuals, and $500,000 for married couples filing together.
To take advantage of this exclusion, you have to pass the IRS ownership and use tests. This means that you’ve lived in and owned the home as your main residence for a minimum of 24 months within the last five years. The good news is, those 24 months don’t need to be consecutive, offering a bit of flexibility. Additionally, you shouldn’t have claimed the exclusion on a different property within the two years prior to selling.
Now, if your home sale profits exceed those thresholds, be prepared to pay capital gains taxes, which can range from 0%, 15%, to 20%, depending on your taxable income. On top of that, you might face a 3.8% net investment income tax if your investment earnings push you over certain limits.
One way to lessen your taxable profit is by boosting your “basis” – the original purchase price of your home. This can be done by adding costs from capital improvements and other related expenses.
If you’re a landlord, though, there’s a bit of a twist. “When renting out the property, you might only be eligible for a fraction of the exclusion,” explains Mark Baran from the financial services company CBIZ. Imagine this: you make a $250,000 profit on your home, but you’ve rented out the property for three of the last five years. That scenario means you’d qualify for only two-fifths of the exclusion, capping the untaxed amount at $100,000. This leaves a significant $150,000 potentially exposed to capital gains taxes, unless adjustments are made to the home’s basis.
However, if the property wasn’t rented out, and you meet the ownership and use criteria, the full exclusion might still be within reach, according to Baran’s insights.
