Housing prices have been soaring recently. Many of you are sitting on large capital gains on your homes. This is especially true of people who have lived in the same home for decades and/or in locations where prices have increased rapidly in recent years.
Will you owe taxes when you sell your home? How can you limit your tax burden? What planning opportunities exist?
Are Taxes Owed on the Sale of a Primary Residence?
The tax code offers a generous exclusion from taxes on gains from the sale of a primary residence in Section 121 of the Internal Revenue Code.
IRS Topic No. 701 provides a high level overview of the tax implications on the sale of your home in easy to understand terms. IRS Publication 523 provides details and calculations for topics discussed below to determine your tax liability.
You can reference these source documents for more details on topics covered. Let’s start with a few key points….
Capital Gain Treatment for Home Sales
If you have a capital gain from the sale of your primary residence, $250,000 of the gain is excluded from taxation for single taxpayers. For taxpayers who use the married filing jointly (MFJ) status, $500,000 of gain is excluded from taxation.
There are a few caveats. You need to meet the ownership test and the use test to qualify for these tax exclusions.
There are also limits on how frequently you can use these exclusions. Finally, there are exceptions for unforeseeable circumstances or hardships that allow for partial exclusions if you don’t fully meet the ownership and use tests.
The ownership test states that you must have owned the home for at least two out of the last five years prior to the sale. For married couples, only one spouse needs to meet this requirement.
The use test states that you must have used the home as your residence for at least two of the last five years prior to the sale. This does not have to be two consecutive years or even two continuous years (i.e. you could have lived there eight months out of the year for the past 3 years).
Unlike the ownership test, if using the MFJ status to file taxes, both spouses need to meet the use test in order to qualify for the full tax exclusion.
Exceptions to Ownership and Use Tests
There are exceptions to the ownership and use tests to still qualify for the full tax exclusion. The most common and likely applicable are related to:
- Separation and divorce
- Death of a spouse
- Extended public service that takes you away from the home.
More details can be found in IRS Publication 523. There are also situations that qualify for reduced exclusion amounts. They are covered below.
Capital Loss Treatment for Home Sales
Your home is considered personal use property. As such, there is no benefit if you experience a capital loss on the sale of your primary residence.
Thus, you can’t use capital losses related to the sale of your home to offset other capital gains or decrease ordinary income as you can with other capital losses, such as losses from a mutual fund investment.
Calculating Capital Gains on a Home Sale
Subtract the adjusted basis in the home from the amount realized in the sale of the home to calculate your capital gain. This is relatively simple. With many people pushing or exceeding the tax exclusion limits, it is important to get this right.
Using the sale price will likely overstate the amount of gain you realized. Using your original purchase price as your basis may understate the amount of capital you have put into the home.
Either error will cause you to overstate your gain. This could leave you with an unnecessary tax liability.
What Is the Amount Realized in a Home Sale
The amount you realize is the sale price of the home minus any selling expenses. The most notable of these are real estate commissions.
If you sell your home for $500,000 using a realtor charging a 6% commission, you would actually only realize $470,000 ($500,000-$30,000).
Other selling expenses that could reduce the amount realized include appraisal, deed preparation, and legal fees.
Calculating a Home’s Adjusted Basis
The other variable needed in calculating the gain on the sale of a home is the adjusted basis. Adjusted basis is calculated by determining the initial basis and then adding to it to account for capital improvements performed during your ownership.
Your initial basis is determined by how you obtained the home, whether by purchasing, inheriting, or having it gifted to you. Assuming you purchased the home, the initial basis is the purchase price plus any additional expenses attributed to initially acquiring the property.
Adjust your initial basis by adding the cost of capital improvements, but not routine repairs and maintenance, made during your ownership. It is important to keep records of these improvements over the years.
If you are approaching or have exceeded the allowable tax exclusions based on your original basis, having good records of these improvements could be very valuable. Let’s consider an example.
Assume you bought a home decades ago for $100,000. In the ensuing decades, prices in that area have increased considerably. The house would now sell for $1 million. If the sellers were a married couple with a $500,000 exclusion, they would still owe taxes on $400,000 of long-term gains.
However, capital improvements like putting on a new roof, putting in a new kitchen, getting a new furnace, adding a patio, etc. over their decades of ownership would increase the basis in the home.
If you spent $200,000 on these projects, that would increase your basis from $100,000 to $300,000. Your taxable gains would be cut in half, saving tens of thousands of dollars in taxes.
Multiple Use Of Exclusions
In general, you can’t claim the Section 121 exclusion if you’ve already used it on another home in the preceding two years. Understanding this rule could be important for planning in a number of situations. I’ll highlight two.
Imagine a married couple with a $400,000 gain on their large primary residence where they raised their family. They also have a second vacation property with a $200,000 gain.
They’ve reached a point in life where they would like to start downsizing. Keeping the large house where they raised their family no longer makes sense. They also would like to sell the vacation property to free up cash to travel to novel places in retirement.
If they sold both properties simultaneously, they would pay no tax on their primary residence. They would realize a $200,000 gain on the vacation home. Assuming a 15% long-term capital gains rate, they would pay $30,000 tax on the sale of this property.
Instead, they could sell the family home with the $400,000 gain first with no tax consequences. If they moved into the vacation property for two years after selling the family home, it would become their primary residence.
Thus they would meet the use test. If they then sold it after living in it for two years, they would owe no tax on this property either. They would save $30,000 capital gains taxes.
Let’s create another hypothetical situation. Dick and Jane marry later in life. Dick was a lifelong bachelor with a home that has a $225,000 gain.
Jane is a widow who stayed in the home where she raised her family. Her home has a $400,000 capital gain.
The couple agrees they would like to sell both homes and start anew together. If they sold both homes before marrying, Dick would pay no tax on the $225,000 gain on his residence.
However, Jane would exceed the $250,000 exclusion for a single. She would owe tax on the $150,000 gain above the exclusion.
Alternatively, Dick could sell his home, recognizing no taxable gain. They could then live together in Jane’s home for two years. After that time, they could sell it and use the $500,000 exclusion available to married couples that meet the ownership and use tests.
The tax code also allows for partial tax exclusions on gains from the sale of a home for taxpayers who don’t meet the ownership and use tests for a wide variety of hardships and unforeseeable circumstances.
The list of hardships and unforeseeable circumstances includes needing to move due to:
- A change in work conditions (transfer by employer or choosing to take a new position)
- Health related issues for yourself or a family member.
- Home destroyed, damaged, or condemned by natural or man-made disaster
- Divorce or separation
- Multiple birth pregnancy
- Financial challenges related to unemployment or change in employment status.
If you qualify for a partial exclusion, you calculate the amount of the exclusion based on how long you lived in the property. Divide the number of days you did meet the ownership and use tests by 730.
The result is the percentage of time in the past two years you met these tests. Multiply that number by either $250,000 (if filing single) or $500,000 (if MFJ) to determine your exclusion.
For example, assume a single person sold a house she lived in for exactly one year. She is moving because her work transferred her out of state.
Dividing 365 (the number of days owning and living in the house) by the 730 divisor equals .5. Next, multiply .5 by her full $250,000 exclusion for a single filer to arrive at her partial exclusion of $125,000. Any gains up to $125,000 recognized on the sale of the home would be tax free.
A full list of conditions that qualify for a partial exclusion and details of the calculations are found in IRS Publication 523.
An Alternative Option — Never Selling
It is worth noting that there is another way to avoid paying capital gains tax on your house– never sell it. This may be the best option for people in a situation where capital gains on your residence far exceed the allowed tax exclusion.
For the vast majority of people, there are no federal inheritance or estate taxes. Estates are exempt from federal taxation unless gross assets and prior taxable gifts exceed $12,060,000 in 2022. There is no federal inheritance tax.
If you can avoid estate and inheritance taxes, you can pass your residence to your heirs who get a step up in basis. Their new basis is the fair market value of the home on the date of the owner’s death. They can then turn around and sell the home with little or no capital gains, and thus little or no taxes.
Take Home Points
The IRS Section 121 tax exclusion on the sale of your home offers a significant tax break when it comes time to sell your home.
It is important to keep good records when selling your home so you don’t overstate the amount you recognize. Likewise, you don’t want to understate the basis in your home because you don’t account for purchasing costs and capital repairs made during your ownership. Either error can cause you to overstate your gains and create an unnecessary tax liability.
You are allowed multiple uses of this exclusion over time. This can present valuable planning opportunities if you time the sales wisely.
There are generous exceptions to the ownership and use tests for some public servants and those who experience hardships. There are also partial exclusions available for a wide variety of hardships and unforeseeable events.
Finally, if all else fails, there is the option to not sell your home and pass it on to your heirs, often with little or no tax consequences.
As with all tax planning topics, it is wise to learn the rules. Apply them to your particular situation to limit your tax burden.
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[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. Now he draws on his experience to write about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. You can reach him at firstname.lastname@example.org.]
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