If your residence has appreciated substantially in value above your mortgage, the untapped equity in your residence is a source of cash. As explained later, this source of cash can be tapped with a home equity loan, the interest on which is fully deductible. But there's another way to use this equity that may be more appealing. You may be able to "trade up" to a new, more expensive home and, in the process, pocket funds from the sale of your present residence, all tax free.
You usually can avoid tax on gain from the sale of your principal residence under the exclusion rules, as explained below. If the proceeds from the sale exceed the amount you need to pay off any existing mortgage on your present home and make the down payment on your new home, you can keep the excess proceeds, free of tax.
EXAMPLE. Suppose you purchased your residence some years ago for $70,000 and have paid your mortgage down to $15,000. You now sell the residence for $140,000. Disregarding selling expenses, this provides cash proceeds to you of $125,000 ($140,000 - $15,000 = $125,000). Now you trade up to a more expensive home costing $225,000, making a down payment of $40,000, with the balance being financed with a new mortgage. You pocket $85,000 in tax-free cash, consisting of the $125,000 cash proceeds you netted on the sale of your old home after paying off its mortgage, less the $40,000 down payment on your new home.
As the example illustrates, at the cost of taking on a larger mortgage with increased monthly payments, you can "cash in" on the appreciation in value of your old residence without incurring tax, assuming your gain does not exceed the $250,000 (or $500,000) exclusion limits, discussed later. Thus, selling and trading up permits you to enjoy the appreciation in value of your old residence without paying tax.