People love to debate the buy vs. rent topic to death. Some are proponents of renting, while those for homebuying say that renters are simply throwing away their money. One potential benefit of buying a home that can't be argued is the $500,000 capital gains home exclusion. 

A married couple filing jointly may be eligible to exclude up to $500,000 in capital gains from the appreciation of their primary home. That leaves a lot of room to benefit from an increase in your home price without being subject to tax. With long-term capital gains rates for top earners as high as 20%, plus an additional 3.8% for the Medicare tax, it could be extremely beneficial to understand how to make sure to qualify for the full $500,000 exclusion. 

Jeff Jones, a certified financial planner with Cypress Financial Planning in Woodbury, NJ, admits that this is a misunderstood rule among many of his clients. "A couple of times a year, a client will fret to me about all the taxes they are going to owe when they sell their house. Once I explain this rule to them, we often conclude that they won't owe any taxes at all," he says.

But can consumers understand this seemingly inscrutable rule more easily?

Breaking Down the Basics

This isn't rocket science. The capital gains exclusion is meant for people that use their homes as their primary residence. Each person has the ability to exclude up to $250,000 in capital gains from the sale of his primary home. Couples that are married and file their taxes jointly may have up to $500,000 in buffer before their home appreciation is subject to taxes. 

To qualify for the exclusion, you'll need to pass the following tests:

1. Ownership: You owned your home for at least two of the past five years leading up to the sale of your home. 

2. Use: You used the home as your primary residence for at least two out of the last five years prior to the sale. The two year period does not have to be continuous and can fall anywhere within the five year period.   

3. Timing: You haven't benefited from the capital gains home exclusion within the past two years. 

If you've lived in your home for two years or more as your primary residence and haven't taken advantage of the capital gains home exclusion in the past two years, then you may be eligible for the full $250,000 exclusion. 

For married couples looking to take advantage of the full $500,000 exclusion, at least one spouse has to meet the ownership requirement while both spouses must meet the use and timing tests, and the couple must file a joint tax return. 

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Jones of Cypress Financial Planning reminds clients that there are other ways to avoid capital gains on the appreciation of your home beyond this exclusion. "If you own a home on the day you pass away, the cost basis of the home is automatically stepped-up to the current value, ultimately accomplishing the same goal," he says.

Capturing a Portion of the Exclusion

If you haven't lived in your home for at least two years, you may still be able to take advantage of a portion of the exclusion if the sale of your home was due to a change in employment, a change in health or some other "unforeseeable event."

To qualify for the change in employment exception, your new job must be at least 50 miles farther from home than your old job location, so job hopping to the competitor next door unfortunately won't qualify you. However, the eligible job change could be for you, your spouse or any other resident of the house.

A change in health could be related to a change in your health or a family member's that required you to move in order to identify, treat or mitigate the illness or to provide medical care for a family member suffering from a disease. 

In terms of an "unforeseeable event," the IRS lays out a couple of examples, such as the death of a spouse, the birth of two or more children from the same pregnancy and unemployment. There could be many other situations that could qualify as "unforeseeable" by the IRS. 

To the extent you do qualify for one of the exceptions above, you would be eligible to exclude a portion of your home appreciation. For example, if you were a single filer who lived in your home for one year, and qualified for the change in employment exception, you would be eligible to exclude up to $125,000 ($250,000 x 12/24 = $125,000) in capital gains from your home sale. 

What If You Have First World Problems?

Before 2008, people were able to shield their home capital gains if they fell within the exclusion amount, even if they used their home primarily as a rental home. They could rent out their home for a period of time, then a couple of years before they were ready to sell, move into the rental home and designate it as their primary home for two years. This allowed them to meet the ownership and use tests and ultimately exclude gains up to the full $250,000/$500.000 capital gains amount. 

That changed somewhat with the Housing Assistance Tax Act of 2008. While you'll still be eligible for the full exclusion after having lived in a home for two out of the past five years, the IRS added that you are only eligible to exclude gains for qualifying use periods. Non-qualifying periods would not be valid and generally include any period of time beginning in 2009, where the property was not used as the primary residence of the taxpayer or spouse. Note, the definition of non-qualified use does not include any periods of time after you used the home as a primary residence. 

What that means in practice is even if your home appreciation is less than the $250,000/$500,000 thresholds, part of your gain may still be subject to tax if there were non-qualifying use periods. For example, let's say you bought a home for $200,000 and lived in it for two years and subsequently rented it out for the following three years. You sold the house after five years for a $50,000 gain or a $250,000 price tag. Even though the $50,000 gain is well below the exclusion amounts, part of that amount, $30,000 ($50,000 x 36/60), would be subject to tax.  

There is some good news though. "Gains are always assumed to be spread evenly across the time period when calculating qualified and non-qualified use, even if the property didn't actually appreciate in a straight line," says Michael Kitces, partner and Director of Financial Planning for Pinnacle Advisory Group and publisher of the financial planning industry blog, Nerd's Eye View. "As a result, even if there were no gains in the value of the property while you lived there, it's still possible for some of your total gains to be allocated to qualified use and be eligible for the exclusion!"

Home of the (Tax) Free

In the end, the capital gains home exclusion is another great tax benefit of owning a home. Especially if you're using your home solely as your primary residence, the capital gains home exclusion should be enough in most situations to help you avoid paying taxes on the appreciation of your home. 

For those using homes for mixed uses, the rules have become a little more complex with the implementation of changes in 2008. It's worth taking some time to fully understand the nuances and ultimately, how to qualify for the maximum exclusion.

Barry Weidenbaum, a Manhattan-based real estate lawyer for Weidenbaum & Harari, also adds to "check the state where the property is located to see if there are any state tax regulations, as the various states may differ on their own rules on taxation and capital gains home exceptions."