Selling a home is a stressful time for most people. However, based on the temperature of the real estate market, it can also be a profitable experience for property owners. While most people recognize that they will have to pay some type of tax after the sale of their home, they often aren’t sure exactly sure of the tax laws or what they’ll ultimately have to pay.
It’s important to note that, although many states follow the same general real estate rules as the federal government, there are some exceptions. It is always advised to contact your state tax department or a trusted tax advisor to ensure you are in compliance with state tax laws. However, at the federal level, the taxability of the sale of your home generally depends on two factors:
- Duration of time you were present and living in the residence
- Total profit made on the sale
Do You Meet The Eligibility Test Requirements?
Most taxpayers don’t realize that if they meet specific eligibility requirements, they can exclude up to the first $250,000 of gain from being taxed ($500,000 if married filing joint) from the sale of a primary residence. Some key “Ifs” to consider about the eligibility test:
- If you acquired the property through a 1031 exchange or are subject to expatriate tax, you do not meet eligibility requirements
- If you owned the home for at least two of the last five years leading up to the date of sale (time of closing), you meet the ownership requirement; if you are married filing jointly, only one spouse has to meet the ownership requirement.
- If you own the home & used it as your primary residence for at least two of the previous five years, you meet the residence requirement. The two years can fall anywhere between the five year period and do not need to be in a single block of time. Unlike the ownership requirement, each spouse must meet this test to get the full exclusion
- If you didn’t sell another home during the two-year period before the date of sale and claim this exclusion, you would meet the look-back requirement.
You’ve Considered Your Gain Eligibility on the Sale – Now What?
For taxpayers who do meet these requirements, the first $250,000 of profit is tax-free ($500,000 if married filing joint). Any gain that can’t be excluded must generally be reported on Form 8949, Sales and Other Dispositions of Capital Assets, and Schedule D (Form 1040), Capital Gains and Losses, and will be subject to capital gains tax rates. Keep in mind this must be your main home, whether in full or partial.
For taxpayers who do not meet any of these requirements, the entire gain on the sale of your home could be subject to capital gains tax. There may be other tax savings strategies you could consider at that point, such as a 1031 exchange if the property qualifies for that treatment, or defer the gain to a Qualified Opportunity Fund (QOF). Losses generated from the sale of your primary residence are not deductible.
Calculating the Gain: Some Basic Considerations
You will have a gain on the sale of your home if your adjusted basis is less than the sales price of your home. Here is a simplified example of figuring your adjusted basis:
- The adjusted basis is equal to the cost you paid for the home, plus any capital improvements made (i.e., additions, new roofing, etc.), less any deductions you have previously taken for tax purposes (i.e., depreciation, casualty losses, energy credits, etc.) It’s important to remember not to omit any commissions, fees, and certain individual selling costs to your adjusted basis to help reduce any gains that may occur.
- You will then take the sales price of the home, and subtract your adjusted basis. If the sales price of your home is greater than your adjusted basis, you have a capital gain. If you qualify for the $250,000/$500,000 exclusion, and your profit is less than the applicable exclusion amount, your gain is tax-free – you will not be subject to any capital gains tax on the profit from the sale.
Selling a Home Also Used for Business/Rental
If you used part of the home (not within your living area) solely for business or rental purposes for a period of time greater than two of the last five years, you would need to make separate gain/loss calculations for the business/rental portions and residency portions of your home. If the space used for business or rental purposes is located within the living area of the house, usage typically won’t affect sale gain or loss. Space used for business or rental may be considered as residence space at the time of sale if specific requirements are met.