If you sold your home last year, or if you are thinking about selling it, you should be aware of the many tax-related issues that could apply to that sale so that you will be prepared at tax time and not have to deal with unpleasant surprises. This article covers home sales and the home-sale gain exclusion, particularly when that gain exclusion applies and what portion of it applies. Certain special issues always affect home sales, such as the use of a portion of the home as an office or daycare center, previous use of the property as a rental, and acquisition in a tax-deferred exchange. Other frequently encountered issues are related to the “2 years out of 5” rules for ownership and use, as these rules must be followed to qualify for gain exclusion.
Home Sale Exclusion – Generally, the tax code allows for the exclusion of up to $250,000 ($500,000 for married couples) of gain from the sale of a primary residence if you lived in it and owned it for at least 2 of the 5 years immediately preceding the sale. You also cannot have previously taken a home-sale exclusion within the 2 years immediately preceding the sale. There is no limit on the number of times you can use the exclusion as long as you meet these time requirements. However, extenuating circumstances can reduce the amount of the exclusion. The home-sale exclusion only applies to a primary residence, not to a second home or a rental property.
2 out of 5 Rule – To qualify for the home-sale gain exclusion, you must have used and owned the home for 2 out the 5 years immediately preceding the sale. If you are married, both you and your spouse must meet the use requirement, but only one of you needs to meet the ownership requirement. Vacations, short absences and short rental periods do not reduce the use period. When only one spouse in a married couple qualifies, the maximum exclusion is limited to $250,000 instead of $500,000. Although this situation is quite rare, if you acquired the home as part of a tax-deferred exchange (sometimes referred to as a 1031 exchange), then you must have owned the home for a minimum of 5 years before the home-gain exclusion can apply.
Some provisions allow you to reduce your gain by a prorated amount if you were required to sell the home because of extenuating circumstances such as a job-related move, a health crisis or other unforeseen events. Another rule extends the 5-year period to account for the deployment of military members and certain other government employees. Please call this office if you have not met the “2 out of 5” rule to see if you qualify for a reduced exclusion.
Business Use of the Home – If you used your home for business—for instance, by claiming a tax deduction for a home office, storing inventory in the home or using it as a daycare center—that deduction probably included an amount to account for the home’s depreciation. In that case, up to the extent of the gain, the claimed depreciation cannot be excluded.
Figuring Gain or Loss from a Sale – The first step is to determine how much the home cost, combining purchase price and the cost of improvements. From this total cost, subtract any claimed casualty losses and any depreciation taken on the home. The result is your tax basis. Next, subtract the sale expenses and this tax basis from the sale price. The result is your net gain or loss on the sale of the home.
If the result is negative, the sale is a loss. However, losses on personal-use property such as homes cannot be claimed for tax purposes.
If the result is a gain, however, subtract any home-gain exclusion (discussed above) up to the extent of the gain. This is your taxable gain, which is, unfortunately, subject to income tax and possibly to the net-investment income tax as well. If you owned the home for at least a year and a day, the gain will a be a long-term capital gain; as such, it will be taxed at the special capital-gains rates, which range from zero for low-income taxpayers to 20% for high-income taxpayers. Depending on the amount of your income, the gain may also be subject to the 3.8% net investment income surtax that was added as part of the Affordable Care Act. The tax computation can be rather complicated, so please call us for assistance.
Another issue that can affect your home’s tax basis (discussed above) applies if you owned your home before May 7, 1997 and purchased it after selling another home. Prior to that date, instead of a home-gain exclusion, any gain from a sale was deferred to the replacement home. Although this is now rare, if it matches your situation, the deferred gain would reduce your current home’s tax basis and add to any gain.
Another Twist – If you previously used your home as a rental property, the law includes a provision that prevents you from excluding any gain attributable to the home’s appreciation while it was a rental. The law’s effective date was the beginning of 2009, which means that you only need to account for rental appreciation starting in that year. This law was passed to prevent landlords moving into their rentals for 2 years so that they could exclude the gains from those properties. Some landlords did this repeatedly.
Records – Assets that are worth hundreds of thousands of dollars, including your home, need your attention, particularly regarding records. When figuring your gain or loss, you will, at a minimum, need the escrow statement from the purchase, a list of improvements (not maintenance work) with receipts, and the final escrow statement from the sale. When you encounter any of the issues discussed in this article, you may need additional documentation.
A few other rare home-sale rules are not included here. As you can see, home-sale computations and tax reporting can be very complicated, so please call us if you need assistance.