Taxpayers may exclude the gain on a home sale, provided they have owned and used the home as a principal residence for two of the five years before the sale. New Internal Revenue Service (IRS) rules now in effect detail the circumstances where at least a partial exclusion of gain may be available.

The basics

If a taxpayer meets the ownership and use tests, he or she will generally only need to report the sale of his or her main home if the gain is more than $250,000 ($500,000 if married and filing a joint return). During the five years ending on the date of the sale, the taxpayer must have:

• Owned the home for at least two years (the ownership test).
• Lived in the home as his or her main home for at least two years (the use test).

If a taxpayer can exclude all of the gain on the sale of the residence, he or she does not need to report the sale of the home on his or her individual income tax return. If there is a gain that cannot be excluded, it is taxable and is reported on Schedule D (Form 1040). The loss on the sale of a personal residence, on the other hand, is not deductible.

Exceptions to the ownership and use tests

If a taxpayer owned and lived in the main home for less than two years, the taxpayer may still be able to claim a reduced capital gains exclusion in some cases. A taxpayer can claim a reduced exclusion if he or she did not meet the two-year ownership and use tests on a home that was sold, or if the capital gains exclusion would have been disallowed because more than one home was sold in a two-year period, when a home is sold because of:

Health reasons

The primary reason for the home sale was to obtain, provide or facilitate the diagnosis, cure, mitigation or treatment of a disease, illness or injury of the taxpayer (includes spouses and co-owners), or to obtain or provide medical or personal care for a taxpayer suffering from a disease, illness or injury. For example, a sale is by reason of health if a physician recommends that a Wisconsin resident with chronic asthma move to a warm, dry climate.

Change in place of employment

The home was sold because change in place of employment occurred during the period of the taxpayer's ownership and use of the principal residence; and the taxpayer's new workplace is at least 50 miles farther from the residence sold than was the prior place of employment. Employment includes starting with a new employer, continuing with the same employer, and starting or continuing self-employment.

Unforeseen circumstances

The residence was sold due to unforeseen circumstances, that is, "an event that the taxpayer could not reasonably have anticipated" before purchasing and occupying the residence. Examples of unforeseen circumstances include a natural disaster such as an earthquake, acts of terrorism, the taxpayer's death (again includes spouses and co-owners), multiple births and divorce.

Exclusions for military personnel

If a taxpayer were on qualified, extended duty in the U.S. Armed Services or the Foreign Service, he or she may suspend the five-year test period for up to 10 years. Qualified, extended duty occurs when the taxpayer is at a duty station at least 50 miles from the residence sold, or is residing, under orders, in government housing for more than 90 days or for an indefinite period.

For example, Sgt. Smith owned and lived in a Wisconsin townhouse for 10 months, then was deployed overseas in February 1991. She returned in 1995 and lived in the townhouse for 16 months before she was assigned to a Texas duty station in August 1996. She married, and she and her husband bought a house in Wisconsin in July 1999. In July 2001, they sold the townhouse. Having lived in the townhouse only one month in the five years preceding its sale, they reported the capital gain on their 2001 return. Under the new rules, they may disregard the time spent overseas and in Texas when determining the five-year test period. Under the new rules, Smith's five-year test period is comprised of the two years from July 1999 to July 2001 when the couple lived nearby, the 16 months she lived in the townhouse in 1995-96, and the 10 months spent in the residence before the February 1991 deployment. During this test period, Smith owned and lived in the townhouse for 26 months, so she may exclude up to $250,000 of gain on the sale. She has until April 15, 2005, to file an amended return claiming a refund of the capital gain tax paid on the excludable amount.