The $250,000 / $500,000 tax-free home sale profit rule is a fantastic benefit for homeowners who have lived in their homes for two out of the past five years before selling. The rule is also called the tax-free exclusion rule for real estate.
The tax-free profit exclusion rule essentially says if you are single, you can earn up to $250,000 in tax-free profits. If you are a married couple, you can earn up to $500,000 as a married couple. This tax-free exclusion rule is one of the reasons why real estate is my favorite asset class to build wealth for regular folks.
If you are in a top marginal income tax bracket, then the tax-free home sale profit rule becomes even more valuable. For example, imagine if President Biden raises the highest marginal tax rate to 39.6%. To earn $500,000 in profits after tax, you would need to have a gross profit of roughly $833,000!
The tax-free profit rule seems straight forward. However, there may be some confusion. So let’s clarify using an example!
Clarifying The $250,000 / $500,000 Tax-Free Home Sale Profit Rule
In the post, Buy Real Estate For Capital Appreciation, Rental Income, or Lifestyle, I responded to one reader by mentioning potentially moving back into his rental for two years in order to take advantage of the tax-free profit exclusion. I said they would have to then sell within five years after moving back to get the benefit..
Here’s a great response from reader who is a tax lawyer about earning tax-free capital gains after selling a home. The tax-free exclusion rule has some nuances you should be aware of before moving back into your rental to save on taxes.
Well, I hate to be the bearer of bad news, but the rule changed a bit starting January 1, 2009. It used to be that the $250,000/$500,000 exclusion applied so long as you lived in the home for any 24 months of the 5 years preceding sale. Now there’s an exception to the exception to the rule in section 121(b)(4). (Note: it’s the second subparagraph (4) under subsection (b)–apparently the legislature mistakenly enacted two sections called (b)(4).)
The IRS chomps away at the $250k/$500k exclusion amount based on a proration of the amount of time that you’ve held the property as a rental since January 1, 2009 (note that it goes back more than 5 years now to look at the use period). The one oddball exception to that (under (b)(4)(c)(ii)) is that if you lived in the home for 2 years during the past 5, and held it out as a rental AFTER you move out, that period is still counted as qualified use.
I mapped this out once about a year ago before selling my residence-turned-rental condo. I determined that it wasn’t worth moving back in to try to recapture a proration of the exclusion amount.
Example. Let’s assume you lived in the house for 2 years starting January 1, 2009. You then converted it to a rental for 2011, 2012, 2013, 2014, 2015. Then you moved back in for 2016 and 2017 and then sold it January 1, 2018. You would have owned it for 9 years total and lived in it for 4. You would be able to exclude 4/9 of $250,000, and that’s it. Better than nothing. But if you’re reaching for the full amount of the capital gains exclusion, it’s not as generous an exclusion as it was before.
Renting Out Your Property Hurts The Tax-Free Home Sale Profit Rule
Bam! I dig the highlighting of section 121 (b)(4)(c)(ii). As you can tell from the above example, as soon as you decide to rent your property out, your tax-free profit exclusion starts getting whittled away.
One might suggest this person live in her place for longer to gain more tax-free benefits. Here’s another example.
Let’s say the person moves back in for 2016, 2017, 2018, 2019, 2020, 2021, 2022, 2023, 2024, 2025, 2026, 2027, 2028, 2029, 2030 and sells in 2031. They would have owned the property for 22 years, and lived in the property for 17 years. Instead of being able to exclude 4/9 of $250,000 ($111,111), they can now exclude 17/22 of $250,000 ($193,181) from the tax man.
The other solution is to never rent out your property, but sell once you want to move. The $250,000 / $500,000 in tax free profits is like making a $357,000 / $714,000 gross return on an investment for someone paying a 30% effective tax rate. That’s some big bucks!
Take a look at the chart I put together for how much in gross profits you need to make with other investments at various effective tax rates.
A 1031 Exchange To Defer Capital Gains Tax
Finally, instead of selling a property for a profit, one can simply conduct a 1031 Exchange. A 1031 exchange is where you buy another property with the profits of the previous property sale so there is never a tax event.
There is no tax shelter available for stock profits, except if you reinvest in an Opportunity Zone fund or investment. But there is a powerful tax shelter for real estate owners. A 1031 Exchange is yet another reason why I prefer real estate to stocks.
The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer’s investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a “paper” gain. — 1031.org
Always Calculate The After-Tax Return On Your Investment
As several commenters mentioned in my Passive Income Rankings post, tax considerations is a huge part of returns. Real estate isn’t at the top of the list due to the work required. However, it’s at the top of the list of money-making assets thanks to depreciation, mortgage interest deduction, the 1031 Exchange, and the $250,000 / $500,000 in tax-free profits upon sale.
The higher your effective tax rate, the more you should love investing in real estate. You should also be maxing out your 401k as well. If tax hikes happen, investing in municipal bonds will also be more attractive.. You might even want to start a lifestyle business one day by launching your own blog.
When it comes to achieving financial freedom, it’s all about generating as much passive income as possible.
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The Tax-Free Profit Exclusion Rule is a Financial Samurai original post. I’ve been writing about personal finance since 2009. Financial Samurai is one of the largest independently-personal finance sites with over 1 million organic visitors a month. Subscribe to my free newsletter below.