By Michael R. Ludin, CPA, tax and audit partner
In recent years, there have been some significant increases in real estate values and many people are considering selling their homes. There could be an income tax impact from that sale. Usually, any income or gain you earn is taxable. However, if you sell your home at a gain, you may not have to pay taxes on that gain.
The first thing to determine is the amount if the gain. The gain is the selling price less selling expenses and the basis (cost) of the home. The cost of the home is the most difficult part of this equation. It is not just the original purchase price of the home, but also includes the cost of all of the improvements made to the home. The improvements could be such items as room additions, a swimming pool and landscaping.
Here are some tips to keep in mind when considering selling your home:
- Exclusion of Gain. You may be able to exclude part or all of the gain from the sale of your home if you meet the eligibility test. Parts of the test involve your ownership and use of the home. You must have owned and used it as your main home for at least two out of the five years before the date of sale. The home must be your main home, so the exclusion does not apply to a gain from selling your vacation home.
- Exclusion Limit. The most gain that a person can exclude from tax is $250,000. This limit is $500,000 for most joint returns.
- Exclusion Frequency Limit. Generally, you may exclude the gain from the sale of your main home only once every two years. Some rare exceptions apply to this rule.
- Exceptions May Apply. There are exceptions to the ownership, use and other rules. Some or all of the gain from the sale may still be excluded even if the ownership and use rules are not met. Some of these exceptions apply to persons with a disability, certain members of the military and those who have sold because a move was needed for health reasons or certain unforeseen circumstances.
- Special Rules if the Home was Used as a Rental. Some people have converted their rental property into their main home, or vice versa. In many of these situations, the gain from the sale must be allocated between the time used as a rental and the time used as a main home. If these rules apply, even if the gain is less than the $250,000 per person exclusion amount, the gain associated with the time used as a rental will still be taxable.
- No Deferral of Gain. The gain from the sale of a home will either be taxable or will be excluded from taxation, or partially both; there is no provision for deferring the taxable gain. Under rules from many years ago people could defer the taxable gain from their home sale by buying a new home within a certain time period. That rule no longer applies. Similarly there is no deferral available under the rules of a Section 1031 Tax Free Exchange.
- Possible Deferral of Tax, Though. If there will be a taxable gain from the sale of the home, one way to defer that tax is to use an installment sale. That is, a sale in which at least one payment from the buyer is received in the future. The taxable gain is reportable on tax returns in the year(s) that the payments are received. The tax, or at least some of it, can be deferred into future years if the payments are stretched out. One further benefit from this is that in some cases smaller amounts of capital gains are taxed at an even lower rate than the already lower capital gains rates – sometimes even taxed at -0- percent! However, the capital gains rates in place in the future years will be applicable to those gains and we can’t be certain of what future tax rates may be enacted by Congress.
- Keep Good Records! We often find that people have little or no records of the original purchase of their home or the improvements they have made. Though these improvements may have taken place over many decades, the supporting documentation will be important to have when it comes tome to report the sale on your tax return, and even more so if the return is selected for audit by the IRS.
- Home Sold at a Loss. If you sell your main home at a loss, you can’t deduct the loss on your tax return.