Depending on how much you profit from the sale of your home, you may have a capital gains tax to pay. Luckily, the Section 121 exclusion gives you some leeway so you may be able to avoid the capital gains tax when you sell your home.
What is a Section 121 exclusion?
If you have a gain of $250,000 or less, or $500,000 for a married couple, the Section 121 exclusion will allow qualified homeowners to avoid paying capital gains tax from the sale. Most homeowners won't have to worry about exceeding this amount, but even if you do, you may still be able to reduce the amount you're paying taxes on.
To calculate the amount you gain from the sale, you'll subtract the sale price, minus any selling costs, from the original purchase price along with the costs of any qualifying home improvements.
For example, let's say you purchased your house for $120,000, and you've put $50,000 of improvements into your house since you've lived there.
$120,000 + $50,000 = a cost basis of $170,000
Ten years later you sell the house for $300,000, and you had a total of $25,000 in selling costs (agent commission, closing costs).
$300,000 - $25,000 = a net of $275,000
$275,000 net - $170,000 cost basis = a capital gain of $105,000
With a Section 121 exclusion, you won't have to pay any taxes on the $105,000 you profited from the sale.
Who qualifies for the exclusion?
Of course, there are limits to who can claim the exclusion. The Internal Revenue Service (IRS) has two tests to determine whether you qualify for the exclusion.
Ownership test: Have you owned your home for at least two years?
The IRS only allows the exclusion if you have owned your home for at least two years. This means you can't flip a house every year and avoid capital gains tax.
Use test: Have you lived in the house for at least two years out of the previous five years?
It's not enough to have just owned the home for two years, you have to have lived in it for at least two years out of the past five. However, these two years don't have to be consecutive. So just because you've owned the house for at least two years doesn't necessarily mean you're off the hook on paying taxes on the gain.
You also might not qualify if you've excluded the gain on the sale of another home within two years of the sale. Publication 523 from the IRS breaks down the eligibility requirements in more detail.