Most people sell their houses for more money than they originally paid to purchase them. The difference between the price you pay to buy a home and the amount you receive when you sell it is generated by some combination of increases in value that have nothing to do with you and improvements that you put into the place. Fortunately, the IRS only defines the first factor as potentially taxable profit.

• Suppose that you buy a house for $200,000 and sell it ten years later for $300,000. While you owned the place, you spent $20,000 remodeling the kitchen and bathroom. According to the IRS, your profit on the sale is $80,000. We'll get into more of the nitty-gritty details about all the items that the IRS requires you to consider in calculating your house sale profits.

Excluding house sale profits from tax
So, you've made a profit of $80,000 on the sale of your home. How much federal tax do you owe on it? Probably none. In fact, thanks to the Taxpayer Relief Act of 1997, single taxpayers can realize up to $250,000 and married couples up to $500,000 of profit on a house sale without having to pay any tax on it. Most people's house sale profits fit well under these limits.

• As long as the house you're selling has been your principal residence for at least two of the previous five years, you can take the tax exclusion at any age and for as many times in your life as you want (but not more than once every two years). There are no restrictions on what you must do with the profits.

• The old rules were much more restrictive: Before, if you were under age 55, you couldn't exclude any gain from tax; you could only "defer" it by purchasing a replacement residence which cost at least as much as the one you sold. If you were over age 55, you could take an exclusion, but it was only for $125,000 and just a once-in-a-lifetime deal.

• In order for a married couple to qualify for the $500,000 exclusion, both spouses must individually meet the qualifications: that is, both spouses must have lived in the house for two of the previous five years and neither spouse can have taken an exclusion on another house sale during the previous two years. If only one spouse qualifies, then the couple is only allowed a $250,000 exclusion.

• If you fail to meet the two-year requirements because of an unexpected move relating to your job, your health, etc., you are still entitled to a prorated amount of the exclusion based on how much time of the two-year requirement you were able to meet.

• If you hold title to your house as a joint tenant with another person, you get a stepped-up basis for tax purposes on half of the property when the other joint tenant dies. If the title to the house is held as community property, both halves of the house get a stepped-up basis when one spouse dies. See the glossary and a good tax/legal advisor for more details.