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DISCLAIMER: As a friendly reminder, this blog post is meant to be used for educational purposes only, not legal or tax advice. If you need help determining the taxes on your home sale, please consult a skilled tax professional.
Owning a house (or two, or three) is an exciting milestone in life, and a quintessential symbol of the American Dream. But selling a house can be particularly daunting, especially when you account for the numerous and vexing tax implications involved.
As if the process of selling a house wasn’t complicated enough, lo and behold Uncle Sam decides to play a mean numerical trick on you when that dreaded tax season rolls around.
After all, the last thing you want after popping the bubbly in celebration of your big home sale is a surprise letter from the Internal Revenue Service (IRS). Or worse yet, finding out after the chips fall that you lost out on big breaks.
Not to worry; we’re here to help you navigate the rules, regulations and stipulations so you can feel more confident about the taxes you owe—or (better yet) don’t owe.
Understanding the capital gains tax break
Before we get to the nitty gritty, know that in most cases when you sell your home, you won’t even need to report the sale to the IRS. That’s because there’s a good chance the profit from your home sale is tax-free.
According to the Section 121 exclusion from the IRS, you won’t need to pay taxes on up to $250,000 of your net profit, or up to $500,000 if filing jointly, if you meet 3 basic requirements:
- You owned the house
- The house was your primary residence for at least 2 full years
- You waited at least 2 full years before using the $250,000/$500,000 tax benefit on another primary house
If all 3 apply to your situation and you sell a house in an affordable area where homes typically don’t fetch more than $250,000 (if you’re single) or $500,000 (if you’re married), you most likely won’t need to report the home sale on your taxes because you’re under the exclusion threshold.
However, if all 3 requirements apply to you and you happen to sell a house in a competitive area where homes are worth upwards of $750,000+, you can apply the tax exclusion on up to $250,000 of your home sale profit if you’re single, or $500,000 if you’re married.
As for your leftover profit, expect to pay taxes on that number. The rate is 0%, 15%, or 20% dependent on your tax bracket.
“Right now, with the way the market is, at least here in Las Vegas, we’re seeing such a large increase in the past couple years of sellers making a significant profit on what they paid for the house, in comparison to what they sold it for,” says Craig Tann of Huntington & Ellis, who is in the top 1% of real estate agents in Las Vegas and ranks in the top 250 agents nationally.
When it comes to taxes, Tann reveals the most common question he hears among savvy sellers—before, during and sometimes even after selling (gasp!)—is: “Am I responsible for paying taxes on the sale of my home?”
“I like to address it upfront with them, if they may potentially be responsible for capital gains tax, and if they need to speak with their Certified Public Accountant (CPA) about what that looks like for them. I’d hate to have that question after closing, and then they find out they’re responsible for 20 or 25 percent in capital gains,” he says.
But once you have this question answered, what happens next? We examined some of the major tax implication trends when selling a house, and spoke with Tann on his experiences working with homeowners.
This beginner’s guide will walk you through the basics of real estate taxes—no matter where you live in the U.S.
Getting started: 5 home sale tax fundamentals
1. Initial tax questions to ask when you’re selling your home
- How long have you owned and lived in the home?
- Was the house you sold your primary home?
- How much profit did you make when you sold the home?
- Did you sell the home for a loss?
- Are you single or married? If married, do/did you file a joint tax return?
The answers to these questions will help you determine if you can take advantage of the capital gains tax exclusion. In particular, you’ll better understand:
- If you need to pay taxes on the profit you made selling your house
- How you can qualify for the capital gains tax break
Depending on where you live or how much your house is worth, you most likely will not have to pay taxes on the profit you made selling your home, unless you made more than $250,000 on the sale (or $500,000 if you’re married and filing a joint tax return).
To qualify for the capital gains exclusion, you have to pass three “tests”:
- The ownership test: You must have owned the home for at least 2 years.
- The use test: You must have lived in the home for at least 2 full years (consecutive or non-consecutive years).
- The “other home” test: You did not exclude your profit from the sale of another home during the 2-year period ending on the date of sale of this home. In other words, you can only exclude 1 home sale every 2 years.
However, Tann says even if you don’t meet all the requirements, you shouldn’t necessarily delay selling your house just because of the tax implications involved.
“If a seller has to move for relocation purposes or because the payments are not affordable or they’re looking to upgrade, although the tax is relevant it may be irrelevant to their situation,” Tann explains. “They should have a conversation with the CPA so they at least know what that looks like for them. And if it’s an investment property then they may want to consider using a 1031 exchange.”
So what’s a CPA and how can you find one? According to the National Association of State Boards of Accountancy, which has been pushing for effectiveness in the accounting profession for over a century, “a CPA license is a symbol to the public that an accountant has mastered the vital elements of the accounting profession.”
To find a CPA for help with your real estate tax questions and needs, you can start by visiting the Association for International Certified Professional Accountants, choosing “For the Public” and then “Find a CPA.”
2. Common tax issues that surface when selling a house
Deciding whether to take the capital gains tax exclusion
If you happen to own more than one home (and lucky you!), you may want to think twice about claiming the exclusion if you plan to sell a home within 2 years of another sale. That allows you to “protect” or defer the exclusion for another house.
On the other hand, if you own multiple homes but don’t plan on selling another home within 2 years, you don’t have to worry about whether it’s in your best interest to claim the exclusion.
Reporting the home sale on my tax return
According to this handy tip sheet from the IRS, “reporting the sale of a home on a tax return is required if all or part of the gain is not excludable.” You must also report the sale if:
- You choose not to claim the exclusion OR
- You receive Form 1099-S (Proceeds from Real Estate Transactions)
Figuring out the gain on the sale of a home
Generally, when you sell your house for more than it cost, you guessed it, you have a gain! However, this number doesn’t tell you the original cost of your house, so for tax reasons you must determine your adjusted basis to figure out whether you’ve really gained or lost in the sale. Your accountant can help with this.
As you might imagine, capital improvements increase your basis—or the amount of your capital investment in assets, like property, for tax purposes.
Keep in mind: On the other side of the coin, if you experienced depreciation, casualty losses or theft losses, “your basis decreases if you must subtract amounts that you previously claimed as tax deductions.”
We recommend reviewing page 7 of Publication 551, which provides a hypothetical example, to help you figure out your own adjusted basis.
In a nutshell, the core formula is:
Original cost of asset
Improvements to asset
Repair of damages to asset
Depreciation to asset
Deducted casualty loss to asset
Adjusted basis of asset
From there, based on the resulting adjusted basis number, you can easily determine your gain number.
Determining the adjusted basis of your home
For tax purposes, once you’ve determined your cost basis—which is a combination of the amount you paid for your house, legal fees, utility connection charges, title fees, transfer taxes and recording fees among others—you will then adjust that numerical basis depending on your situation.
According to HomeGuides by SFGate, the established home section of the sister-site of the San Francisco Chronicle, here are some specific scenarios that can increase or decrease your cost basis:
Adjustments that increase cost basis:
- Add major improvements that increased your home’s value, prolonged its life or gave it new use
- Add special tax assessment for improvements levied by your local government (i.e. installing streetlights)
- Add expenses from repairs after a casualty (i.e. fire, earthquake, hurricane, tornado)
Because these adjustments increase your home’s cost basis they can reduce your home sale profit.
Adjustments that decrease cost basis:
- Subtract insured losses (in which case you must “subtract all of your insurance proceeds from your basis since you added the entire cost of the repair to your basis.”)
- Subtract settlement fees or closing costs
- Subtract money you received for doing things that reduce your property’s value (i.e. selling rights-of-way or easements)
- Subtract anything you already deducted elsewhere
(Note: According to the IRS, if some or all of your property is used for business, an income-producing activity or a home office, you should have claimed depreciation—“a tax deduction that allows a taxpayer to recover the cost or other basis of certain property”—against the business use of the property. If this applies to you, you’re required to subtract the depreciation deduction from your basis, whether or not you claimed it on your taxes.)
Consider if any of the above adjustments apply to you, and then add or subtract them from your home’s cost basis. This number is your adjusted basis.
Understanding how postponed gains work under old ‘rollover’ rules
Before May 6, 1997, if you sold your house and used the gain to buy a new one at equal or greater price, you could postpone paying tax on that profit until whenever you sold that new house.
After May 6, 1997—when President Bill Clinton abolished the rollover with the Taxpayer Relief Act of 1997—through today, you can no longer defer paying taxes on your home sale gain by buying an equal-priced or more expensive home.
Instead, you now only have two options:
- Exclude your gain on the sale
- Report your gain on the sale as taxable income in the year sold
3. Special tax circumstances you may fall under
As a homeowner, you likely fall in one of three camps: you purchased your home from someone, you built your home or you inherited your home.
Generally speaking, the original cost of your home is the amount you paid for it. However, depending on the scenario that applies to you, how you acquired the home, what you paid for it, when you paid for it and to whom you paid for it matters.
Here’s a breakdown of the scenarios to help you determine the original cost of your home:
You purchased your home from someone
This one might be obvious, but the price you paid for the house is your purchase price—including settlement or closing costs, your down payment and any debt assumed, according to Publication 530 from the IRS.
You built your home
If you constructed your house—or contracted to have it built on land you own—the amount you paid, including “closing costs paid when you bought the land or settled on your mortgage” is the cost of your home. The ‘basis’ also includes expenses involving: labor and materials, contractor fees, architect fees, building permit charges, utility meter and connection charges, applicable legal fees.
(Note: For those who purchased or built a home: The IRS doesn’t allow you to include the sales taxes as part of your cost basis if you choose to deduct those taxes as itemized deductions on Schedule A (Form 1040).
You inherited your home
According to Turbo Tax, a tax preparation software company trusted since 1993, the cost basis on inherited assets, like property, is the “the fair market value of your home on the date of the previous owner’s death.” But what exactly is fair market value? It’s the price an asset would command in the marketplace. If you don’t sell the house within a year of inheritance, Bankrate, a popular personal finance website, suggests hiring a professional certified appraiser to arrive at the fair market value asking price for you.
You’re converting a second home to a primary home
If you happen to own a second home, whether it’s a vacation bungalow off the coast of California, a rental cottage in Cape Cod or some other dreamy escape, it’s tricky to take advantage of the tax benefit that allows married homeowners to claim up to $500,000 of tax-free gains when they sell their primary house.
To claim the benefit, you need to live in the second home for at least 2 years.
Qualifying for a reduced exclusion
If you don’t qualify for the capital gains tax exclusion, you may qualify for a reduced exclusion if “the living conditions of a qualified individual changes,” according to H&R Block, a global tax services provider founded in 1955.
So who’s considered a qualified individual in this scenario?
- Your spouse
- A co-owner
- A resident
In most cases, you can qualify for and claim a reduced exclusion if you sold your house for any of the following reasons:
- You moved for a new job AND a) that new job is at least 50 miles farther from your new house than your previous job (or, if you didn’t have a previous employer, at least 50 miles farther from your previous home) and b) you changed your employment situation while you still owned and lived in the house.
- Your qualified family member—living in your house—has a disease, illness or injury and you have to sell your property to a) get them a diagnosis, a cure, mitigation or treatment OR b) because a doctor recommends a change of residence for medical or personal care reasons
- You experience unforeseen personal, familial or environmental circumstances such as:
- Becoming eligible for unemployment compensation
- Being unable to pay for basic living expenses
- Employment changes
- Involuntary conversions, such as your house being destroyed, condemned or under threat of condemnation
- Multiple births from the same pregnancy (twins or triplets)
- Natural or man-made disasters
4. Things you can do to stay in the IRS’s good graces
Initiate a tax conversation with a real estate agent.
If your real estate agent hasn’t brought up real estate taxes and what you might owe after closing on the sale of your house, it’s in your best interest to take charge and initiate that conversation with them, though they will be limited in what they can tell you.
Ideally, you should speak with a CPA as well, so you don’t experience any surprises come tax season.
“I’ve heard stories from agents who didn’t have a conversation with the seller about their tax implications, and they missed a deadline by a week or two weeks or a month. Stories about how the seller didn’t have to specifically sell, and they could have waited another 30 days, but now there’s some sort of tax implication. Agents who didn’t advise the client and who, unfortunately, sold and closed the house before a deadline,” Tann explains.
See a tax advisor
Tax rules and regulations are constantly changing from year to year, decade to decade and even administration to administration.
Tann advocates that one of the best things you can do when selling your home is to see a tax advisor.
“There are so many factors that come into play that the agent should have some sort of basic knowledge [of real estate taxes]. But again, sellers want to go to a tax advisor to get proper advice on what the best course of action for them is.”
Tann explains the importance and sensitivity of the matter with the following example:
If a homeowner occupies a house, and they’re at the 1-year and 10-month mark (and, thus, 2 months away from the two-year threshold described earlier), Tann says they want to do one of two things: either hold off on the 2 months or, if they put the house on the market, work the contract so that the closing takes place after the two-year deadline.
5. Tax and real estate documents you should keep handy
Though it’s uncommon for a real estate agent or broker, Tann says his team at Huntington & Ellis sends every client—who sold or purchased a home in the previous year—a copy of their closing statement in the mail by mid-January or February.
The closing statement includes a letter explaining why they need it, and that they need to provide it to their CPA.
“We noticed—five or six years ago—that clients were calling, or their CPAs were calling, asking us for a copy of their closing statement. So we figured that instead of having them call us we would initiate.”
If you happen to be working with an agent who doesn’t provide that service automatically, you can simply request the closing statement from the agent or the title company that closed out the sale of your house.
According to the IRS, Form 1099-S (Proceeds From Real Estate Transactions) is needed “to report the sale or exchange of real estate.”
This form usually comes directly from the title company in the mail by mid-February, so keep your eyes peeled for it then because, as Tann explains, it will help you determine whether you have to pay taxes on the profit you made.
Big takeaways for taxes on selling your house
For the sake of your wallet (and sanity), selling your house while oblivious about your tax obligations is a fundamental no-no.
Be proactive throughout the year by making appointments with a tax advisor or CPA, starting tax conversations with your agent and keeping receipts on all your property expenses, like home improvements or remodeling.
Bring these papers with your newfound tax background in tow, so you can feel empowered when you file in the spring—no matter the outcome.
Though the tax implications of selling a house are relatively black-and-white, meaning you will or will not have to pay taxes on the profit you make after closing, the sensitivity of the matter stems from the strict timeframes and thresholds the IRS enforces.
While top real estate agents should have a basic understanding of the financial implications of selling a home, you should talk about most of your tax questions and concerns with a tax advisor. Choose a professional who is equipped with the most up-to-date information for any given year, and who you trust to discuss your situation openly and freely.
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