New Rules on Home-Sale Profits

One of the greatest tax breaks for homeowners -- in addition to being able to deduct property taxes and mortgage interest -- is the ability to claim tax-free profits on the sale of a principal residence.

Individuals can exclude up to $250,000 of profit and married couples filing jointly can exclude up to $500,000 of profit when they sell a house that they lived in for at least two out of five years prior to the sale. Two recent changes in the tax code affect the home-sale exclusion rule as it applies to widows and widowers and to owners of vacation homes.

Previously, the full $500,000 exclusion could be claimed by a surviving spouse only if the home was sold in the year that a joint return was filed, which generally is limited to the year when the spouse dies. But starting in 2008, a surviving spouse may exclude up to $500,000 of profit from the sale of the principal residence if the sale occurs within two years of the spouse’s death.

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If you own a vacation home, get ready to say goodbye to a sweet deal. Under current law, people who make a vacation place their principal residence for at least two years before they sell it may take advantage of the full $250,000/$500,000 exclusion of profits from the sale of the home. But if you turn your vacation home into your principal residence after 2008, part of the home-sale profit will be taxed. Any gain that occurs during the time you owned the house after 2008 and did not use it as your principal residence won’t qualify for the home-sale exclusion.

For example, say you bought a vacation home in 2000, turned it into your primary residence in 2011 and sold it in 2015. In this case, one-eighth of the profits would be taxable (assuming your overall profit did not exceed the $250,000/$500,000 tax-free limit). That's because the home was not your primary residence for two years after 2008 (2009 and 2010) before you converted it to your principal residence. Therefore, the appreciation that occurred during two of the 16 years that you owned the property would not qualify for tax-free treatment.

The change may not affect those who have more than $250,000/$500,000 of appreciation, says Harris Abrams, senior tax analyst for the tax and accounting business of Thomson Reuters. That's because the change reduces the portion of the gain that is eligible for the exclusion; it does not reduce the maximum exclusion amount. Any appreciation in excess of the $250,000/$500,000 exclusion limits would be taxed at capital-gains rates.