Overview

• As part of the Taxpayer Relief Act of 1997, Congress amended the Internal Revenue Code's language allowing taxpayers to exclude a limited amount of the profits or gains realized when they sold residential real estate. The capital gains tax laws passed in 1997 allow you to exclude up to $250,000 in taxable gains or real estate profits if you sell your primary residence and did not use it as rental property. If you did, you might have to pay capital gains taxes on the sale of your primary residence, but at a lower income tax rate, according to the Taxpayer Relief Act.
  
  

General Requirements

• You may qualify for the residential real estate tax benefits if you meet the IRS' income test, principal residency test, past sale test and ownership test. According to the Internal Revenue Code, you can have only one primary residence at once. Thus, if you own two homes, only one will count as your primary residence. However, a primary residence can later become a second home, and vice versa.
  
  

Calculating Gains or Profits

• Typically, the gain or profit you earn is the difference between your selling price and purchase price (basis). However, you might be able to take advantage of the adjusted basis rules to increase your initial basis, and in turn, you can keep more of your profits. The IRS allows you to exclude up to $250,000 of gain if you are single. If you are married, you can double that figure, excluding up to $500,000 of capital gains.
  
  

Ownership and Principal Residence Tests

• If you owned your property for two of the last five years before the closing date of your sale, you pass the ownership test. If you lived in your home and used it as your principal residence for two years of the last five years, you pass the principal residency test.
  
  

Exceptions

• The mandatory two-year residence requirement does not have to be continuous, and as long as you lived in your home for a total of two years within the last five years of ownership, you are OK. In other words, if you sell your home in 2011, and you lived in it for all of 2007 and all of 2009, you can tack your years together for a total of two years. If you did not sell another principal residence within the last two years, you meet the past sales test.
  
  

Reporting Capital Gains

• If you need to report any income from the sale of your primary residence, use Schedule D of IRS Form 1040. Schedule D, Capital Gains and Losses, allows you to report your profits as capital gains. Your settlement attorney or agent might require you to sign an IRS affidavit at closing or attestation for reporting income tax purposes.