When a person sells their principal residence, specific tax implications must be considered. Under Internal Revenue Code (IRC) Section 121, a taxpayer may exclude up to $250,000 ($500,000 for married couples filing jointly) of gain from the sale of a principal residence, as long as specific requirements are met.

To qualify for the exclusion, the taxpayer must have owned and lived in the residence as their primary home for at least two of the five years prior to the sale. This is known as the “ownership and use test.” In addition, the taxpayer cannot have excluded gain from the sale of another home during the two years prior to the sale of the current home.

It is important to note that if the taxpayer does not meet the ownership and use test or has excluded gain from the sale of another home within the two years, they may still be eligible for a partial exclusion of gain if they meet specific requirements under IRC Section 121(c). This includes cases where the sale is due to a change in place of employment, health reasons, or unforeseen circumstances.

Another consideration for a principal residence sale is the reporting of the sale on the taxpayer’s tax return. The sale must be reported on Form 8949, Sales and Other Dispositions of Capital Assets, and the gain or loss from the sale must be reported on Schedule D, Capital Gains and Losses. If the gain from the sale is excluded under IRC Section 121, the taxpayer should indicate this on Form 8949 and Schedule D.

Furthermore, Suppose a taxpayer has a mortgage on the principal residence and the sale price is less than the outstanding balance. In that case, the difference between the sale price and the outstanding mortgage balance is considered a “debt forgiveness.” This is normally considered as income and it is taxable. Still, there is an exclusion under IRC section 108(a)(1)(E), which excludes the debt forgiveness from being considered as income in the case of a principal residence.

In conclusion, when a person sells their principal residence, there are specific tax implications that must be considered. Under Internal Revenue Code (IRC) Section 121, a taxpayer may exclude up to $250,000 ($500,000 for married couples filing jointly) of gain from the sale of a principal residence, as long as specific requirements are met. It is essential to report the sale correctly on the taxpayer’s tax return. If the gain from the sale is excluded under IRC Section 121, the taxpayer should indicate this on Form 8949 and Schedule D. Additionally, if the sale price is less than the outstanding balance on the mortgage, the difference between the sale price and the outstanding mortgage balance is considered a “debt forgiveness” but it can be excluded from income under IRC section 108(a)(1)(E) in the case of a principal residence.