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Owning a home can be a pain. But it also can provide one of the best tax breaks around, the ability to exclude a substantial amount of sale profit from taxation. Of course, you must comply with the tax law and various Internal Revenue Service rules and regulations to get the tax benefit. Read on to find out how.
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Last week was one of those that made me tell the hubby I was ready to call a “We Pay Cash for Homes” operation.
He’s heard that before.
Over our four+ decades together, we’ve owned five residences of different sizes, styles, ages, and in different parts of the country. All have needed maintenance and varying degrees of repairs.
And in every one, from the condo to the older homes to the one we watched be built, I’ve run into an issue that’s been particularly problematic. Hence, the repeated “I just want to be done with and out of this place!” outbursts.
The hubby long ago learned to just let me vent (on this and other things; he’s no fool!). He knows that I don’t mean it, at least not the part about calling one of the cash offering companies.
That’s good, since the deals usually cost the home sellers profit they would have pocketed if they’ve gone the usual sales route.
And from a federal tax standpoint, that means the sellers also waste a major home seller tax break.
Tax-free home sale profit. Sorta: A home is the largest single investment most of us make. It also offers most of us the largest single capital transaction, as in capital gains, that we will ever make.
The National Association of Realters says that in June the national median existing home sale price for all housing types was $440,600. That was a 1.8 percent increase from the price of $432,700 one year ago, and was the 36th consecutive month of year-over-year price increases.
While real estate markets vary across the United States, it’s likely that in most of last month’s property transfers the sellers made a profit.
It’s also likely that they, like sellers before them across the country, were able to keep a large part, and possibly all, of that profit from the Internal Revenue Service.
Under current tax law, a single home seller won’t owe tax on up to $250,000 of the property’s sale profits. Up to $500,000 in residential sale profit is free from federal tax when the sellers are a married jointly filing couple.
But since we’re talking taxes, there’s more (and more math) to it. In addition to the sales price and your marital status, there’s your former home’s basis, and timing to take into account to ensure that your home sale profit is indeed tax-free.
Residential requirement: The good news is that for tax purposes the IRS’ interpretation of your home is pretty lenient.
You home can be a single-family house, condominium, cooperative apartment (co-op), mobile home, house trailer, or even a houseboat.
But the main factor for home sale purposes is whether your home was your principal residence. To determine that, the IRS uses the old standby of facts and circumstances.
If you own only one piece of real estate, the answer as to whether it is your main home is pretty clear. But if you multiple properties, such as a house in the suburbs and smaller one on a lake, the IRS looks at the place where you spend most of your time.
That’s the key issue, but not the only one. It also has a list of additional residential indicators, such as where you work in relation to the property, where your family lives, and the address where bills are correspondence are sent, as well as the one on your driver’s license, vehicle registration, voter rolls, and (you guessed it) on federal and state income tax returns.
Unless you’re intentionally trying to confuse (or evade) officials (or law enforcement), the IRS will have no problem agreeing that the home you sold was your primary residence and the other property you still own is a vacation home.
Spending the majority of your time at the house you sold also bolsters your legitimate claim that it was your primary residence.
But that’s just one timing consideration when it comes to excluding home sale profit.
Five and two year requirements: Tax law and IRS regulations say that during a five-year period ending on the date of the sale, you must have owned the home and lived in it as your main residence for at least two years.
Those yearly measurements are applied in the three following ways.
| 1. You must own the house for at least two years. Married couples need to note who’s on the deed. If it’s just one spouse, then that owner must meet this ownership time. But both of you must live in the house the requisite length of time, two years, to pass the use test. |
| 2. You must live in the house as your primary residence for two of five years before you sell it. The good news here is that that the two years don’t have to be consecutive. But unlike the ownership rule for a married jointly filing couple, the requirement on the time living there applies to both spouses, even if only one is the owner. |
| 3. You must not have claim the home-sale exclusion within the last two year. This limit was created to keep house flippers from serial selling at a rapid pace and avoiding capital gains tax on their profits. Married couples again need to be careful here. If either spouse sold a home and used the capital gains tax exemption within the last two years, then the couple can’t take advantage of it again on their jointly sold home. |
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Figuring, and reducing, taxable profit: Okay, you meet the owning and residing in requirements. Now it’s time to calculate just how much of home sale is protected from taxation.
First, don’t conflate the sales price you got with the profit, also known as the taxable gain, you made on the sale. They are two different amounts.
You do start with that sales price you got. Then you subtract your home’s basis from the sale amount. Your residence’s basis basically is what you paid for the house plus any improvements.
That means the material upgrades you made to your house, while not being a direct tax savings when you shelled out the money to the contractor, can help you when you sell. They add to your basis, and the larger that amount is, the less your profit for tax purposes.
Here’s where those good records you kept of qualifying house work, such as a room addition or substantial landscaping help. If you’re near the trigger point on your home sale profit limit, those added basis costs could save you thousands in potential capital gains taxes.
When the computations are done, then those six-figure dollar home sale tax exemption amounts of $250,000 for single sellers and $500,000 for married jointly filing couples apply to your profit.
So, taking your home’s basis into account, the $750,000 you and your spouse got for your residence won’t automatically cost you any taxes.
Partial exclusions for certain circumstances: Ideally, we buy a house, we happily live in it for many years, we sell it at a profit that’s no more than the exclusion amount for our filing status.
But like isn’t always or even usually ideal. Luckily for us, the tax law provides some relief in these cases.
If a taxpayer fails the normal ownership, use, or frequency tests, a reduced exclusion may be available when the sale is due to a change in place of employment, health, or unforeseen circumstances.
This relief can be helpful on the tax front when you must sell because of a job relocation, illness, divorce, casualty, other unexpected family changes, or other unexpected events.
Nonresidential home usage has a tax cost: If your sold home was strictly your residence, no problem. But some homeowners sometimes use part of their house to conduct business.
Or during a financially difficult time they rented out a room to help cover living expenses. Or what became your main residence was your vacation home before you moved in full-time.
Each of these actions could affect the amount of nontaxable home sale profit you can claim.
If any of these other home uses apply to the house sold (or plan to sell), talk with a tax professional who has real estate tax experience.
Other tax-related home sale circumstances: That tax pro also can answer questions about certain home sale rules that allow qualified members of the uniformed military services, the foreign service, intelligence community, or Peace Corps may elect to suspend the five-year test period for up to 10 years.
There also are special timing considerations when a homeowner loses a spouse. The unmarried surviving spouse may qualify for the $500,000 exclusion if the sale occurs within two years and the joint exclusion requirements were met immediately before death. After that, the surviving spouse can still tack the deceased spouse’s periods of ownership and use to their own to qualify for the standard $250,000 exclusion.
What are known as involuntary conversions get special tax treatment, too. These include the destruction, theft, seizure, or condemnation of a home and are treated as a sale for principal residence gain exclusion purposes as long as the usual ownership and use tests are met. This lets the affected taxpayer exclude gain from insurance proceeds or other compensation as if it were a residential sale.
Then there are the cases where a home seller might decide the gain exclusion is not the right tax move. For example, choosing to pay tax on the profit can work for a taxpayer who sells two homes within a two-year period, and the second home sale produces a larger gain that is covered by the full exclusion.
Again, a tax pro can help guide you through these special home sale tax situations.
Even if your home sale situation seems relatively simple, as the requirements discussed earlier show, the tax exclusion is not automatic, so sound tax advice could help.
And if it turns out you can’t exclude as much as you’d hoped, at least knowing that in advance and claiming the correct exclusion is far better than hearing about it later via IRS questions about your filing.
You also might find these items of interest:
- Is moving for tax reasons worth the effort? It depends
- Popular home-related tax benefits already in the tax code
- Lower your property tax bill with appraisal appeals and exemptions
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