The Home Sale Tax Exemption
Before the 1997 Taxpayer Relief Act, you could find yourself facing significant capital gains taxes on the sale of your house. Capital gains taxes are taxes on any profit you make from the sale of a capital asset, such as a house. These taxes were applied unless you upgraded to a home with a more expensive purchase price.
With the passage of the Act, however, individuals can lower their tax liability from the sale of their home and exclude up to $250,000 of capital gains from taxation. Married couples can exclude up to $500,000. Tax rates are usually up to 15%.
Here's an example: Say you're selling a house for $550,00, and you originally purchased the home for $250,000. You made a profit of $300,000. If you are unmarried, you can exclude $250,000 in taxes. You will only pay taxes at a rate of 15% on the remaining $50,000, so about $7,500. If you are married, you can exclude $500,000, so the entire profit is tax-free.
Calculating the Profit on the Sale of a Home
First, look at the original purchase price of your primary residence. These extra fees are not tax deductions, but they do count toward the total cost basis of your principal residence:
- Closing costs
- Attorney fees
- Real estate agent fees
Now, look at the selling price. The profit you make may be tax-free, depending on your tax bracket. When calculating your gain, you do not include mortgage or real estate taxes that you've paid on the home. But you should subtract any past claimed tax credits for home improvements from your cost basis. Home improvements also usually help the house sell for a higher sale price, which sometimes helps you make a profit. It's important to note that this tax break does not apply to a second home or investment property. It only applies to the sale of your main home.
You may qualify for a tax break on the sale of an investment property by taking advantage of a like-kind exchange. Properties are considered “like-kind" if they are used for the same nature or character. For example, let's say you own a property that you use for your small business. You decide it's time to sell that property and buy a business property closer to your home. You can postpone paying capital gains on any profit you make as part of a qualifying like-kind exchange. However, the capital gains you make from the sale are tax-deferred, not tax-free.
Requirements for Married Capital Gains Exclusion Amount
You must be legally married and complete married filings for your taxes. The $500,000 tax break will not be "taxable income" as long as you file a joint return in the same tax year you purchase your new home. The capital gains tax rate also depends on how long you've lived in the house before you sell it. In general, a short-term capital gains tax rate will apply if you've owned the home for less than a year. The short-term capital gains tax rate is equivalent to your income tax rate. This means the IRS treats the taxable gain on your home as ordinary income. In contrast, a long-term capital gains tax rate applies if you've owned the home for over a year. Certified Public Accountants (CPA) encourage their clients to hold onto their assets for longer than a year because a long-term capital gains tax rate can help reduce a client's tax bill.
The "Use" Test and the Home Sale Tax Exemption
Federal tax exemption rules have some strict exceptions that you need to understand. Not following these rules can get you in trouble with the IRS during the sale of your home. Trying to work around these laws is tax fraud.
Exemption Limited to Every Two Years
You can only qualify for the home sale exemption from the capital gains tax once every two years. This is sometimes called the "two-year rule." The IRS measures the two years beginning with the date of the sale of your home.
The Use Test
To qualify for the home sale capital gains tax exemption, you must pass the use test. This test looks at whether you "used" or lived in your home. You must have owned and lived in the residence for at least two out of the last five years before the sale. That time does not have to be continuous.
For example, say you lived in the house for the first year. You rented the house as a rental property for three years, and you lived in the house for the fifth year. In this example, you have lived in the house for two of the five years, so you still qualify for the exemption for tax purposes.
If You Fail the Use Test
Even if you fail the use test above, you can still get a prorated exclusion on your capital gains. This exception applies if you sold your house because of a change in employment, health reasons, or other unforeseen circumstances.
For example, if you only live in a house for a year because of a job change, you are entitled to a $125,000 exemption (half of the $250,000 unmarried exemption you would have received).
Nursing Home Exception
In general, a person is required to own and live in a house for two of the last five years to qualify for the tax exemption. However, people who end up living in a nursing home can have this requirement lessened to one out of five years. Time spent in the nursing home counts towards the use test as if it were the original home.
Home Office Exception
If you are self-employed and taking depreciation deductions for a home office, that amount will be subtracted from your capital gains exclusion. For example, say you were normally entitled to $250,000. You took $50,000 in tax deductions for a home office. You would only be entitled to a $200,000 exclusion from your capital gains.
Types of Homeowners and the Home Sale Tax Exemption
The kind of owner you are and your tax filing status can change your exemptions. This is sometimes called the "ownership test."
If each individual passes the use test, then each individual is entitled to a $250,000 exemption from capital gains taxes. This means that if you co-owned a house with another individual but were unmarried, each individual can exclude $250,000 of capital gains from taxation.
Married couples who file jointly are entitled to a $500,000 exclusion from capital gains taxes. Tax laws say either spouse can own the residence. However, both spouses must meet the use test.
Newly Married Couples Bonus
If an unmarried couple bought a house and lived in it for one and a half years and then got married, they can use that year and a half towards the two-year period requirement. This means they only need to live in the house as a married couple for six more months to qualify for the $500,000 tax exclusion.
Divorced couples can add the ownership and use of their former spouse to meet the use test. For example, say a couple lives in a house as their main home for a year and a half. They get divorced, and the wife gets the house. The wife would only need to live in the house for an additional six months to qualify for the home sale tax exemption.
If a Sale Will Exceed the Home Sale Tax Exemption
The sale of your house might exceed the capital gains exclusion. If this is the case, consider alternative ways of structuring the use and ownership of your home to maximize the possible exclusions.
For example, assume you are a married couple who has an adult daughter living with you. The sale of your house will generate $750,000 in profit. You can consider giving that daughter one-third ownership of the house. Now, you can apply your $500,000 towards the $500,000 you and your spouse would receive as profit. If your daughter has owned and lived in the house for two years, she would also qualify for a $250,000 exclusion as an individual. This would allow you, as a family, to get a total of $750,000 in profits and have all of it excluded from capital gains taxation.
Questions About the Home Sale Tax Exemption? Ask an Attorney
If you're thinking of selling your home and are concerned about capital gains taxes, there are several things you can do.
While researching on your own might sound like the cheapest way to proceed, you shouldn't gamble on your finances. Contact a local real estate attorney to learn more about the home sale tax exemption and whether or not it applies to your unique situation.
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