Who qualifies for a tax exclusion?

PASADENA, CA - SEPTEMBER 24: A "for sale"

PASADENA, CA - SEPTEMBER 24: A "for sale" sign stands outside an existing home on September 24, 2009 in Pasadena, California. Although home resale numbers have been gaining over the past four months, an unexpected decline occurred last month with sales dropping 2.7 percent to a seasonally adjusted annual rate of 5.1 million in August. July sales were 5.24 million. Still, the numbers were up 3.4 percent from a year earlier. Almost one in three homes last month were purchased by first-time home buyers who will get an $8,000 tax credit if the transaction is completed by November 30 when the credit expires. (Photo by David McNew/Getty Images) (Credit: GETTY IMAGES/David McNew)

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Q: I have some questions regarding the tax exclusion homeowners are entitled to when they sell their primary residence. Let's say a homeowner who has lived in his primary residence for at least two of the past five years is selling his home.

As I understand it, he is allowed to keep up to $250,000 tax free of the profits. But let's say that six months to a year prior to the home sale, the homeowner marries and files jointly. Although one of the individuals hasn't lived in the home for the full two years, would they still be allowed to take up to $500,000 tax free?

Also, let's say there is some profit above the $500,000 or $250,000 (if the spouse is ineligible). Will the amount be taxed at the marginal tax bracket of the individual or couple or is it a flat 3 percent or 4 percent on the amount?

A: According to IRS Publication 523, by selling your home, you and your spouse would qualify for the $500,000 exclusion if all of the following is true: you are married and file a joint return for the year in which you sell the home; either you or your spouse meets the ownership test, in which you or your spouse owned the property and lived in it as a primary residence for at least two of the past five years; and, during the two-year period ending on the date of the sale, neither you nor your spouse excluded gain from the sale of another home.

If the owner of the property has only owned the property for 18 months before selling, he can take a proportionate share of the profits as an exclusion on his federal (and typically state) income tax return.

So, if you lived there for 18 months (1.5 years), you'd multiply your profits by 0.75 (or 75 percent of the two years required to take the full $250,000 tax free). If you're married, you'd use $500,000 instead of $250,000.

To answer your second question, for profits in excess of what you can legally exclude, you'll pay long-term capital gains tax, up to 20 percent, depending on your income level.

That is dictated by how much you and your spouse (if you have one) earn. For more details, check out IRS Publication 523, Selling Your Home. (http://www.irs.gov/pub/irs-pdf/p523.pdf)

Q: Thanks for the great information you provide through your free weekly newsletter and column.

I have a question. I currently own a home and owe $388,000 on the mortgage. I think the home is probably worth $370,000. I bought the home for $417,000 in 2006, so I've taken a big hit on equity like everyone else.

I have no issue making the payments, but feel as though I am trying to dig myself out of a hole. I make an extra payment a year plus pay an additional $200 each month toward the principal on the loan.

Given how low interest rates are right now, do you think it would make sense to just sell my house at a loss and trade up now?

I live in a starter home and think it makes sense to trade up while prices on bigger houses and mortgage interest rates are really low.

I could easily afford to buy a home for $600,000 to $700,000 and put down close to 20 percent. Am I crazy to want to make the move now?

A: I can just imagine all the e-mails I'm going to get from Realtors wondering if they can sign you up as a client!

Seriously, I think there are a lot of buyers wondering the same thing: Is now the best time to trade up and buy a bigger house while mortgage interest rates are still low?

If you want to buy a bigger house, now is the time. You'll have to make good on what you owe on your current home, but if you can sell and get out, good for you. Then, you can shop around for the bigger property that you want and buy at today's relatively low prices.

I'd love to see you put down 20 percent, because otherwise you'll get killed on private mortgage insurance. Also, you'd want to make sure you don't get a loan bigger than $417,000 so that you're in the conventional market.

Keeping the big picture in mind (you're losing a little money on one house but hopefully making it up by buying a home that you can stay in for the long run at an equally reduced price) is a smart way to go.

To put it differently, if real estate prices had increased across the board, you would sell your place at a profit but have to buy your next place at an increased price. It's all relative. If you plan to live in a home for the long term, you might find the right home for yourself now and lock in an interest rate that appeals to your budget as well.

Here's another reason to move now: There may be uncertainty in the market coming down the line with proposals that may do away with Fannie Mae and Freddie Mac. Some of those proposals may cause interest rates for homebuyers to go up and may make it harder for some homebuyers to get money together to buy their homes.

I think you're on the right path. Hope this helps.

(Ilyce R. Glink's latest book is "Buy, Close, Move In!" If you have questions, you can call her radio show toll-free (800-972-8255) any Sunday, from 11a-1p EST. Contact Ilyce through her Web site, www.thinkglink.com.)

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