One of the best available tax breaks for individuals (not corporate, trust or partnership entities) was created in the Taxpayer Relief Act of 1997 which allows qualifying individual taxpayers to exclude all or a portion of the gain from the sale of their home (principal residence) from income taxes. Basically under Section 121 of the Internal Revenue Code, single taxpayers may exclude up to $250,000 of gain ($500,000 of gain for joint returns).
In order to qualify for the tax free treatment on the gain the individual taxpayer must satisfy an ownership, use, and frequency test. The ownership test requires that the individual taxpayer own the home (the deed is in your name) for at least two (2) out of the past five (5) years. The use test requires that the individual taxpayer uses the home as his or her principal residence (you live in and occupy the home as opposed to renting the home). The frequency test means that the exclusion can only be used once every two years.
There are special rules for joint returns. The joint $500,000 exclusion is available if:
a. Either spouse meets the ownership test; and
b. Both spouses must meet the use test; and
c. Neither spouse excluded a gain in the last two (2) years.
A reduced exclusion is available where the ownership and use test is not met. The reduced exclusion is available where the sale of your home was due to a change in employment, bad health, or unforeseen circumstances.
You must report the sale of your home on your tax return if you:
a. Receive a Form 1099-S, Proceeds From Real Estate Transactions or
b. A portion of the gain is taxable or not excluded.
If neither of the above applies then you do not have to report the gain from the sale of your home.
If the amount of the gain on the sale of your home exceeds the $250,000 or $500,000 exclusion then the excess gain is reported as a long term capital gain on your Schedule D and receives the favorable benefit of the lower long term capital gain tax rate. Unfortunately, if you experience a loss on the sale of your home the loss is not deductible on your tax return since the IRS considers it a personal loss.