You’re probably aware that when you sell your home, you may exclude up to $250,000 of your gain from tax if you’re unmarried (or married, filing separately) and $500,000 if you are married and file jointly. To claim the whole exclusion, you must have owned and lived in your home as your principal residence for an aggregate of at least two of the five years before the sale. You can claim the exclusion once every two years.
Two year rule exceptions
There can be exceptions to the two-year rule. One such exception relates to the disposition of the home due to an involuntary conversion (discussed in more detail later). An example is when a home is destroyed by a fire before two years of occupancy as a principal residence has passed. In this situation, a partial exclusion may be applicable.
If a casualty completely destroys the principal residence, the taxpayer may also, within two years of the date of the involuntary conversion, apply any remaining exclusion to the sale of the vacant land on which the destroyed home sat. The law treats the sale of the house because of the involuntary conversion and the subsequent sale of the land on which it sat as one sale.
Here is an example. John, a single taxpayer, owned a house destroyed in a fire. John had a basis in the land and home of $240,000 ($40,000 for the land and $200,000 for the house). On the fire date, the house had an FMV of $450,000, and the land had an FMV of $100,000. John’s insurance company paid him $450,000 for the destruction of the house.
John decided to purchase a home in a different part of the same city. John sold the land three months after the fire for $101,000. John elects to apply the Sec. 121 exclusion to the involuntary conversion and to the sale of the land. Because the law treats them as one sale, John’s amount realized is $551,000 ($450,000 insurance payment + $101,000 sales price of the land). John’s gain realized is $311,000 ($551,000 − $240,000). He excludes $250,000 of the $311,000 gain realized.
The home sale exclusion is one of the great tax benefits of home ownership. Many home sellers owe no tax at all when they sell their homes.
Reporting the sale of your home on your return
If a home sale is tax-free due to the exclusion, do you need to report the sale to the IRS on your tax return? It depends.
Your home sale may have already been reported to the IRS by your real estate agent, closing company, mortgage lender, or attorney. The IRS has a special information return for this purpose: Form 1099-S, Proceeds from Real Estate Transactions. This form lists the gross proceeds from the sale, the property address, and the closing date.
IRS Form 1099-S
Typically, the 1099-S is issued at the home sale closing and is included in the closing documents you receive at settlement. If you received a Form 1099-S, you must report the sale on your tax return, even if your entire gain is tax-free due to the $250,000/$500,000 exclusion. Failure to do so will result in the IRS assuming that the selling price is the taxable gain (that can lead to an audit – an often stressful and costly experience).
Form 1099-S need not be filed by the escrow company if your home sold for less than the applicable $250,000/$500,000 exclusion and you sign a certification stating that you qualified for the exclusion. You generally do this at the closing.
If Form 1099-S was not issued, the IRS does not require you to report the sale on your return. But doing so anyway can be a good idea because it can prevent the IRS from asserting that the six-year statute of limitations on audits should apply because you omitted more than 25 percent of gross income from your return.
Involuntary Conversion
Another situation can affect the current taxability of the gain on the disposition of a residence due to “involuntary conversion.” An involuntary conversion is the conversion of property into money or other property due to its total or partial destruction, theft, seizure, condemnation, or threat of condemnation. For example, gain can result when the insurance company pays an insured an amount greater than the taxpayer’s basis in the property. This is most likely to occur when the home was purchased many years ago but was insured for its current market value.
This scenario may apply to many homeowners who lost their homes in the recent wildfires in Los Angeles County in January 2025.
Under Sec. 121 of the Internal Revenue Code, taxpayers may be able to exclude all or a portion of the gain from an involuntary conversion of a principal residence if they meet the previously discussed ownership and use requirements.
When taxpayers’ principal residences are destroyed or lost through condemnation, under Sec. 1033, they may defer gain realized by replacing the principal residence, either in exchange for replacement property (direct) or by receiving cash and purchasing similar property within two years from the end of the tax year (indirect). Taxpayers may use Sec. 121 and Sec. 1033 to exclude and defer respective gain portions from the same involuntary conversion.
Here is an example of how the deferral works. Jack, a single individual, has owned and lived in the same house for 10 years. He has a basis in the house of $150,000. A fire completely destroys his house. Jack’s insurance company pays him $550,000. Jack’s gain realized is $400,000 ($550,000 − $150,000). He elects to use Sec. 121 to exclude $250,000 of the gain on the involuntary conversion of the principal residence. Therefore, Jack’s amount realized after consideration of Sec. 121 is $300,000 ($550,000 − $250,000).
Jack’s gain realized is $150,000 ($300,000 − $150,000). If he elects to use Sec. 1033 and purchases a replacement property at a cost of at least the amount realized of $300,000, Jack will be able to defer all the gain realized on the involuntary conversion. However, if he purchases a home at a cost of $200,000, Jack will recognize a gain of $100,000 ($300,000 − $200,000) and pay capital gains tax on that amount. The remaining gain of $50,000 is deferred under Sec. 1033, but he must reduce the basis in the replacement property by the $50,000 deferred gain.
Electing out of the exclusion
If the gain on the sale or exchange or involuntary conversion of the taxpayer’s principal residence qualifies for the exclusion, the taxpayer may elect for the exclusion not to apply. A taxpayer might want to elect out of the Sec. 121 exclusion and instead elect to defer all the gain realized as an involuntary conversion.
Electing out of the exclusion might be desirable when the gain is small, and the taxpayer plans to buy or construct a new home that costs more than the amount realized on the involuntary conversion. The taxpayer could defer all the gain and use the exclusion on a later sale.
This election out of the exclusion would be especially desirable if the taxpayer expects property values to increase substantially in the next two years and the taxpayer expects to sell the home shortly thereafter because the taxpayer may use the benefits of the exclusion only once every two years
How to report your home sale on your return
Reporting the sale of a principal residence is not difficult. You must file IRS Form 8949, Sales and Other Dispositions of Capital Assets, with your annual return and enter your gain (if any) on IRS Schedule D. It is usually advisable to attach a statement to the return explaining the computation of the gain – especially if an involuntary conversion is involved. Seeking professional assistance with the preparation of such a return would be worthy of consideration.