Tax Ramifications of Selling your Home
With home prices skyrocketing, many homeowners have taken the opportunity to sell their homes in order to cash in on their equity. However, many have not thought about the tax effect of that sale and may be in for an unpleasant surprise when they file their tax return. In the case of a home which has been used solely as your principal residence, here is what you should know.
1. Your home is a capital asset. If you have owned the home for one year or more, any gain is a long-term capital gain and taxed at capital gain rates. If you have owned the home for less than one year, any gain is short term capital gain and taxed at ordinary rates.
2. If you have a loss on the sale of your home, the loss is not deductible as the home is a personal and not a business asset.
3. The gain/loss on the sale of your home is calculated by subtracting your “basis” in the home from the sales price. The calculation of basis is very important since certain transactions will increase basis and therefore reduce the gain on the sale of the property.
4. The computation of basis begins with the original purchase price of the home. Here is where proper documentation becomes important as basis is increased by expenses reflected on the original closing statement or incurred in preparation for the closing. In general, the expenses incurred at the time of purchase that increase basis are: owner’s title insurance, recording costs, abstract fees, survey fees, legal fees, amounts paid on behalf of the seller, installation of utility services and transfer taxes. This is not an exhaustive list, but does include the most common adjustments. For more information see: https://www.irs.gov/pub/irs-pdf/p551.pdf
5. Basis is further increased by capital improvements to the property. Repairs and maintenance do not adjust the basis in the property. Thus, building a pool or making an addition to your home will increase the basis in your property, as will replacing your entire roof or rewiring your house. On the other hand, painting your house, or fixing a leaking roof will not affect the property’s basis. Again, this is where recordkeeping is key, especially if you have owned your house for a long time and have made improvements throughout the years.
6. Basis can also be decreased. In the case of personal property there are generally not too many items that decrease basis, but several important adjustments are residential energy credits (for example, a credit for solar energy or energy efficient roofs), casualty and theft losses and insurance reimbursements. This list is not exhaustive, but details the most common adjustments. For more information refer to the publication cited above.
7. By now you should have a good idea of the amount of gain you would have, if you were to sell your home. The good news is that not all of the gain will be taxable. The tax laws do allow for an exclusion from income for the gain on the sale of a principal home if certain requirements are met. There are four requirements.
a) Eligibility Test: If you acquired your property in a like kind exchange or are subject to the expatriate tax you are not eligible for the exclusion.
b) Ownership Test: You must have owned the home for two out of the five years prior to the sale. In the case of married taxpayers, only one of the taxpayers needs to satisfy this requirement.
c) Residence Test: The property must have been your principal residence for 24 months of the five years prior to the sale. The period of residency does not have to be consecutive so long as the period falls within the last five years. In the case of married taxpayers, both must meet the residence test.
d) Lookback Test: You cannot have excluded income from the sale of a principal home within the last two years prior to the current sale. That is, you can take the exclusion only once during a two-year period.
8. If all the tests are satisfied, married individuals may exclude $500,000 of the gain on the sale of their principal home from income. Individuals who are single or married filing separately may exclude $250,000 of gain from the sale of their principal home. For more information see: https://www.irs.gov/pub/irs-pdf/p523.pdf
9. If all requirements are met, the sale of a principal home does not have to be reported on the tax return if all gain is excluded. If the gain is higher than the exclusion amount, then the sale must be reported on the return and tax paid on the gain over and above the exclusion. However, if a Form 1099-S was issued to the seller, then the sale of the home must be reported on the return even if all the gain would be excluded from income.
These are the general rules applicable to taxpayers selling their home. There are many exceptions to these rules. In certain circumstances it may also be possible to qualify for a partial exclusion of gain from the sale of a principal residence. These exceptions are beyond the scope of this article. If you are contemplating the sale of your home and do not meet the general rules of eligibility, reach out to a tax professional to discuss your personal circumstances.