Last week we covered the tax implications of purchasing and owning a home. Now we move on to the third phase: taxation of the sale of your home. We will deal with the sale of a home you own or owned as your residence; rental or other investment properties are another topic.
The big issue with the sale of a primary residence is whether you get to use the Section 121 exclusion on capital gains. This exclusion is huge. For single taxpayers who qualify, it is $250,000; for married filing jointly $500,000.
But, as always, rules apply. You need to meet the criteria for this exclusion to apply. If you do, then those amounts of gain are excluded, meaning you are not taxed on gains up to that amount; you pay tax only on capital gains to the extent they are over those exclusions.
Ownership and Use Tests
To qualify for the exclusion, you have to meet both the ownership and use tests.
The ownership test is that you have been the owner for 24 months of the past five years. For married filing jointly, this test can be met by one of the spouses; you can take the full exclusion even if only one of you owned the property.
The use test requires you used the home as your primary residence for 24 months out of the last five years. This does not have to be continuous; you can have lived there multiple times that add up to 24 months.
This test has to be met by both spouses for a full exclusion of $500,000 — even if only one of you owned it, you both had to live there. Otherwise, you can get the $250,000 exclusion.
Primary residence means that it is your main home, and the IRS provides some good guidance on what this means.
It’s okay if you owned multiple homes, but only one can be your primary residence at any point in time.
In addition to your living there, in order for the home to be your primary residence, you must get your mail there and be registered to vote there, and it must be near your workplace, if you work. You can also support this by it being in close proximity to family or clubs you belong to.
There is also a look-back period. You can use the exclusion only once during a two-year period. You can have sold another home but not used the exclusion; the look back is to make sure you didn’t use the exclusion.
Widowed owners can treat the sale as if they are still married if they sell within two years of their spouse’s death but not if they have remarried before the sale.
If you can’t use the exclusion, you may have taxable capital gains. You may also need to know the gain exactly if it is close to or exceeds the exemption amount for your filing status.
The gain is the extent that the amount realized, or net selling price, exceeds your adjusted cost basis. Let’s break that down.
If you subtract the costs of selling (such as realtor’s fees) from the sales price, you obtain the amount you realized from the sale. This is your net selling price.
The adjusted cost basis is the original purchase price of your home, adjusted for improvements. If you’ve made significant improvements to the home, such as a new roof or remodeling a kitchen, you can add the costs of those improvements to your basis.
This effectively increases the amount of your investment, reducing the taxable portion of your capital gains.
You can’t add maintenance costs (such as repainting) to your basis. Any item you add to the basis must still be a part of the house. For example, if you installed carpeting and later ripped it up to put in hardwoods, only the cost of the latter flooring would add to your basis.
Once you have calculated your adjusted basis, you subtract it from your net selling price to determine your gain on the sale. If you have a loss on the sale of a personal residence, it is not deductible for tax purposes.
There are some additional rules that apply to some situations. Active-duty military personnel may be able to include duty time away from their home in meeting the use test. Moving after less than two years of ownership or use can result in a partial exemption if the move is necessary for work or medical reasons.
The applicable details related to specific situations can be found in IRS publication 523, “Selling Your Home.”
For many people, buying or selling a home is a rare occurrence and it is driven by where they need to live for work or other reasons. But there are some planning opportunities that can make a big difference for some people.
If you currently have multiple homes that qualify for the exemption, the timing of your sales becomes very important.
If there is little gain in one home and you sell it first, you may want to pass on taking the exclusion, leaving it for the larger gain.
If you have a home with a lot of gain, nearing the exclusion, you might consider a move that would use the exemption.
For example, you and your spouse have nearly $500,000 of gain in a home in an area where you expect real estate to continue to appreciate. You also may expect to live in the area for quite a bit longer. You could sell your home and move to a similarly priced home, using the exclusion to avoid tax on the capital gains and have a much higher basis in the new home.
If you are considering downsizing or upsizing or some other change this could be a very big long-term play, effectively making use of the exclusion twice instead of once.
These are big decisions and should be done only after thinking through all the details, preferably with the advice of a financial advisor or tax professional.
Many people don’t like paperwork. Knowing how gain is calculated and what can increase your basis may inspire some better record keeping for some homeowners.
It’s great to know that the pool you’re considering can increase your home’s basis and potentially help with taxes later on; it’s another thing to find documentation for the pool you put in just 10 years ago when you need to substantiate the amount.
Keeping your records is still important.
Many people will be able to use the exclusion to offset at least part of their gains. Timing is important: You need to meet both the ownership and use tests, and it would be a shame to miss by a couple weeks when there’s a large gain on the line. Often transactions fall within the exclusion — with some planning you may be able to make sure yours does.