Here are three words you don’t hear everyday: Tax-free money.
There aren’t too many things you can say that about, but for many homeowners that sell, it is true since profits on most home sales are excluded from taxable income.
According to TurboTax, most home sellers don’t even have to report home sales to the IRS.
You exclude home sale profit from your taxable income with three tests:
1. Ownership: You owned the home as your main residence for at least two years of the five years prior to sale.
2. Use: The home was your main residence for at least two years of the five years prior to the sale. So if you lived in a house for 10 years and then rented it out for two years before you sold, you would qualify for this exclusion.
3. Timing: You did not sell another house and exclude profit from that sale within two years prior to the sale.
If you meet these three tests, you can exclude up to $250,000 in profit from your taxable income. If you are married and filing a joint return, you can exclude up to $500,000 in profit. At least one spouse must have lived in the home for two of the five years prior to the sale.
The tax rules also allow for some special circumstances.
If your spouse dies and you have not remarried, you can count the period that the deceased spouse owned and used the property as the test for use. Military or foreign service personnel can often get an exception to the use test. There are also some exceptions in case of divorce or separation.
Of course, if you are lucky enough to make more than $250,000 (or $500,000 if you are married and filing jointly), the situation changes. These profits are considered capital gains and are taxed. Depending on your income, they can be taxed from 0 to 20 percent.
Retirees who show this kind of profit on a home sale should speak to a financial advisor, since profits that large could increase income and Medicare premiums.