Q: When I sell my principal residence and make a profit, how do I know how much tax to pay?

A: Hopefully, you will have no tax due if you qualify under section 121 of the IRS code. The more formal name is "the exclusion of gain on the sale of a principal residence" rule.

And in its simplest translation, it says that if you owned and occupied your principal residence for any two of the five years immediately preceding the day you sell it, then you can skip paying tax on the first quarter million dollars of profit per owner, up to a half million dollars for a married couple filing a joint return.

Q: What do you mean when you say "profit?"

A: Technically, the IRS means "capital gain." Your net selling price is the sales price minus any selling expenses, such as commissions or concessions you made. Your basis is the amount you paid for the house when you bought it, plus any major improvements you have made along the way. The IRS says your net selling price less your basis equals your capital gain.

Q: So, what if I am single, and I make more than $250,000 when I sell?

A: You would exclude the first $250,000 from taxation, and the remainder would be taxed as any other capital gain. The current federal tax on long term capital gains is 15%, and the state of Georgia wants another 6%, for a total of 21% tax on the amount not excluded under Section 121.

Q: What if I got married a week before I sold the house?

A: If you are married on the date you sell your residence, and you file a joint tax return for the year of sale, then you could exclude up to $500,000 from taxation. It is a specified benefit in the IRS code for being married. Your spouse need not ever have been in ownership or listed on title.

Q: Don’t I have to be age 55, and don’t I have to re-invest within two years?

A: No, that is the old rule which no longer applies. There is no longer any age requirement. The rules of Section 121 apply to all who own and occupy their principal residence.

You don’t have to re-invest in anything, and you can do whatever you choose with the money.

Q: Is this a "once in a lifetime" exclusion?

A: No, that was also in the old rules. Instead, you can claim an exclusion under Section 121 as often as once every two years, for as long as you live.

Q: What is the definition of a principal residence?

A: The IRS has covered that in a lot of detail, but for starters, you can only have one principal residence at a time, and it is most often the house where you spend the majority of nights in any one year. Indicators would include where you get your mail, where you answer the phone, where you are registered to vote, and the address you listed on your tax return for that year.

You can change your principal residence at any time, but it’s a good idea to talk with your tax advisor when you do so.

Q: Could I buy an ugly duckling house, move in and fix it up in my spare time, then sell it two years later for a lot more and pay no taxes on the profit?

A: Yes, you could exclude from taxation entirely the first $250,000 of gain if you were single, and twice that if you were married. And you can do that every two years for as long as you wish.

Q: If I did that, would the materials and supplies I used to fix the house up be tax deductible?

A: Typically not. Performing repairs and improvements to your residence are usually not tax deductible for the homeowner, although the overall plan of improvement might constitute a capital improvement, and that could increase your basis for tax purposes.

A good example of a capital improvement would be adding a deck or enclosing a garage to make a bedroom or other living area. The value of adding to your basis is that it decreases the amount of your gain at time of sale. Again, talk to your tax professional.

Q: When I sell, what IRS form do I file to tell them I plan to exclude gain under this rule?

A: If you have no gain over the excluded amount, there is no form to file at all. You are not even required to notify the IRS that you sold your residence unless there is gain in excess of the allowable exclusion.

Q: If we have a large gain trapped in our house now, is there any advantage to going ahead and selling now as opposed to waiting?

A: I suppose you could make a case for selling now, so that future appreciation would accrue to the next residence as opposed to being taxable once you exceed the limit of the exclusion.

In addition, there is always the possibility that Congress might change the rules, reducing or eliminating the exclusion, or adding some sort of means testing. By selling now, you lock in the savings of the current exclusion.

As always, it’s a good idea to talk to your tax professional before you undertake any major life decision, and selling your home is one of those times.