Don't be surprised by a tax liability on a sale of your residence.

Regularly, clients contact me to discuss the tax consequences of selling their primary residence. It seems there is a lot of misinformation floating around that I aim to clarify below.

Rollover proceeds from a sale

It is common for sellers who have been in their homes for quite some time to cite the “old” rollover rule. Before May 7, 1997, taxpayers could avoid paying taxes on profits from the sale of their principal residence by using the proceeds to purchase another home within two years. Sellers over age 55 had the option of a once-in-a-lifetime tax exemption of up to $125,000 of profits.

Home sale gain exclusion

Internal Revenue Code Section 121 replaced the old rollover rule and allowed taxpayers to exclude gains from the disposition of their home if certain requirements are met.

In order to qualify for the gain exclusion, a taxpayer must own and occupy the property as a principal residence for two of the five years immediately preceding the sale. If a taxpayer has more than one home, the gain can only be excluded from the sale of their main home. In cases where there are two homes that are lived in, the main home is generally the one that is lived in the most.

If the requirements are met, taxpayers may be able to exclude up to $250,000 of gain from their income ($500,000 on a joint return) and are not obligated to reinvest the proceeds.

Sale of a multi-family home

I was recently able to provide guidance to married taxpayers who sold their property. This particular property was a side-by-side duplex where the taxpayers occupied one side as their principal residence for approximately 10 years and rented the other. The taxpayer was familiar with the $500,000 exclusion and the gross proceeds were slightly below that amount. During sales negotiations, they were incorrectly advised that the proposed sale of their principal residence with a gain under $500,000 would result in no income taxes owed after the sale. Needless to say, there was an unexpected surprise when I discussed the true income tax consequences with them.

Selling a duplex is conceptually akin to selling two separate properties. The side the taxpayers occupied is afforded the same tax treatment as any other principal residence, which includes the Section 121 gain exclusion up to $500,000 for married taxpayers. However, the investment side of the duplex is subject to capital gains tax and depreciation recapture taxes. In this particular instance, there was approximately $30,000 of combined federal and state income taxes owed as a result of the sale.

Under current law, taxpayers can sell their principal residence and exclude $250,000 of taxable gain ($500,000 for those married filing jointly). The requirements to reinvest the proceeds or to roll them into a new property have been inapplicable for some time. Taxpayers are free to use the proceeds from the sale in any manner without tainting the exclusion.