Tax on Home Sales

Selling your home can result in a substantial gain.  As with most realized financial gains, there are taxes too.  However, the tax code offers breaks to some sellers of real estate.  In this article we will cover excluding a portion of your profit from taxes, figuring the gain on sale, and the lower rates applicable to long term capital gains. 

Figuring the Gain on Sale

The gain on the sale of property is calculated as follows:

            Sale Amount
less       Selling Costs
less                    Basis
=                Gain(loss)

Basis is generally the cost of the property and certain improvements.  Determining basis is covered in detail below. 

Exclusion of Gain from Taxation

If you qualify, you may be able to exclude some or all of the gain on the sale of your home from taxation.  Up to $250,000 ($500,000 for married couples filing jointly) may be excluded if you meet two tests:

1. Ownership Test: You must own the property for 2 or more years during the 5 years preceding the date of sale.
2. Use Test: You must have used the property as your principal residence for two or more years during the 5 years preceding the date of sale.

To qualify for the larger $500,000 exclusion available to married couples filing jointly, both spouses must meet the use test requirements and at least one spouse must meet the ownership test criteria.    If only one spouse meets the use test, the exclusion is limited to $250,000.

Once you utilize the gain on sale of primary residence exclusion, you must wait two years before claiming it again. 

Nonqualified Use

Use of the property as other than your principal residence, may be nonqualified use.  If nonqualified use applies, a percentage of the realized gain must be included as a taxable gain.  The percentage of gain that must be recognized is the ratio of:

period of nonqualified use/time taxpayer owned home

This does not necessarily reduce the maximum exclusion; it reduces the realized gain that is eligible for exclusion.  Nonqualified use does not include anytime during the 5 years preceding the sale, after the 2-year tests have been met.

Unforeseen Circumstances

Sometimes unforeseen circumstances can force a home sale.  In certain cases, such as health issues, change of employment or unforeseen financial difficulties, one may need to sell before meeting the criteria of the ownership and/or use tests.  In these scenarios, you may be able to make a partial exclusion.  The criteria for this should be discussed with a tax pro. 

Determining Basis

Figuring the taxable gain on the sale depends on your home’s basis.  Basis generally starts with the purchase of the home and is then adjusted for other items.  Basis is subtracted from sale proceeds in determining the gain.  Therefore, total basis reduces total gain.  Adding to basis, where permissible, reduces taxable gain. 

Basis begins with the cost of the home.  Improvements to the home are added to basis and thus reduce your gain.  Improvements are expenditures that add value, prolong life, or adapt to different uses.  For example, new windows in a home are an improvement and get added to basis.  Repairing a broken window is just a repair, does not qualify as an improvement, and does not impact basis. 

Improvements with an expected life of less than 1 year are not added to basis. Improvements that are no longer present, such as a new, installed carpet that has since been replaced, are not included in basis. 

Closing Costs and Fees

Certain purchase closing costs and fees increase basis.  These include:

• Title and abstract fees
• Charges for installing utilities
• Legal fees for title search, preparing sales contract/deed
• Recording fees
• Survey fees
• Transfer/Stamp tax
• Owner’s title insurance

Tax Rates and Home Sales

Preferable tax rates are sometimes available for home sales.  If you owned your home for more than 1 year, generally your gains that cannot be excluded are taxed at the more favorable Long Term Capital Gains rates. 

Long term gains rates are 0%, 15% or 20%.  The rate steps up as income climbs through each bracket.  Long term gains ‘float’ on top of your regular income and are structured so that they are not taxed at a higher rate than ordinary income (exceptions apply for other property types and depreciated property)

Long term capital gains rates and brackets are available here.

Net Investment Income Tax

Gains on the sale of a home may be subject to a 3.8% investment income tax for certain higher income taxpayers.  Discuss your home sale with a tax pro to ensure compliance with this rule. 

Conclusion

The IRS offers some benefits to home sellers.  Selling your home can lead to a substantial gain, so the tax savings can be significant.  Because of the large dollar amounts involved, be sure to understand the tax rules.  It is usually wise to work with a tax pro before and after the sale. Please contact Aaron Hoffman to discuss taxes and how we can help.

This site contains general information for taxpayers.  Each situation depends on its unique facts.  Do not rely on this content as a sole source of information.  Seek professional advice before taking any action based on this information.