Selling your home can net you a big return. But what does the taxman have to say about it? Taxes on capital gains can get you big-time in certain situations, so it is important to understand how capital gains applies to your home sale before you try to rake in the money. Luckily the rules have changed since 1997, making it easier for you to sell your home and realize a profit. This is good news for anyone wanting to sell a home right now. Understanding how capital gains work when selling a home is important.
New Real Estate Capital Gains Rules After 1997
If you sold a home pre-1997, you may be surprised to hear about the generous tax break you can get on your home sale. This is because the current laws went into effect on May 7, 1997. This law is referred to as The Tax Payer Relief Act of 1997. Before this time, you had to take the profit from your home sale and use it to buy another, more expensive house, within a period of two years. If you didn’t do this, taxation on your profits was inevitable.
The only other option you had to protect your earnings was based on age. If you were 55 or over, you could take a special exemption one time in your life, of up to $125,000. Either way, you had to fill out a special form to prove to the IRS that you were following the rules.
The current laws went into effect with the Taxpayer Relief Act of 1997. This act made it much easier to sell your residence and enjoy the profit from the sale. You can still use the money to buy a new home. But you can also use it to buy a boat, car, or vacation. It’s up to you. When you are selling a home it is important to understand how they tax laws work just like when you are purchasing property, you should know the home buying tax deductions. Understanding tax laws can save you thousands of dollars every year if you know what to look for.
Real Estate Capital Gains Explained
Real estate capital gains are, fortunately, one of the best tax breaks available to the average person. This means that in most situations, you have little to worry about unless your home is going to bring in a great deal of money. You have to realize large gains on your personal home before you pay a penny to taxes. In most instances, the rules are as follows:
- If you are single, you can make up to $250,000 in profits on your home sale before you have to pay taxes.
- If you are married, you can make up to $500,000 in profits before paying capital gains tax.
Here is an example of the real estate capital gains law: Lets say you were fortunate to purchase your home for $500,000 and it is now worth $800,000. Your $300,000 in profit or gain would not be taxed if you are married as the $500,000 in profit is excluded from taxation.
So what happens if you are going to make more than $500,000 in profit? Under the current tax laws you would be taxed at a 20% capital gains tax rate on the amount over the $500,000 threshold.
This is pretty exciting news for most home sellers. Granted, there are areas that have seen serious real estate booms, where you may be able to go over these numbers when you sell. But for most home sellers, there is little worry of needing to pay Uncle Sam for their home sale.
However, you do have to meet all of the requirements. Let’s explore those requirements so you can see how they apply to you:
principal residence – This tax break is designed for people who are selling the home they live in, not investment property. You have to live in this residence for two out of the last five years. Practically speaking, two years is not a long time to make a home your residence. And the best part of this requirement is that it applies repeatedly. You can live in a home for two years, sell with no penalty, buy another home and live there for two years, sell again. There are no limits on how many times you can use this as long as you meet the two year requirement. As far as living in the home for two out of the last five years, there are no hard and fast rules regarding this situation. You could have lived in the home the 1st year, rented it the next three, and lived in it again in the last year and you would be fine as far as the capital gains exclusion goes. Years ago when the real estate market was a whole lot different I had a friend who lived in Southborough Massachusetts that would make a habit of of living in a home for a couple years and then selling. He would do this every few years when the real estate market was on an upswing. He would avoid pay capital gains taxes by following the code to a tee.
- This does not apply to your vacation home – Keep in mind that selling your vacation or second home does not yield the same tax benefits. Even if you move into the second home and live there for two years, some of the profit from the sale will still be taxable, based on how long the residence was used as a secondary home.
- Getting married can help – That doubled amount – $500,000 for married couples – is awfully appealing for some couples that have yet to marry. The tax laws are pretty forgiving here. If you get married only a short time before the sale, you can still qualify for the higher break if both of you have been living in the home for two years. So if you were living together for a year and a half, then get married and sell six months later, you should be able to qualify for the $500,000.
- Understand your new spouse’s home sale history – Although the law is fairly lenient on residency times for marriages, it is not so lenient on previous uses of the exclusion. If your new spouse used the home sale exclusion within the past two year – like selling his own house to move in with you – this will impact your ability to use it for the current home sale. If he just sold the house, you will need to wait a full two years before you can take advantage of the full exclusion. You may be able to get a partial exclusion though, depending on your situation.
Wealthy Tax Loophole Closed
In 2009 there was a law put into effect that closed a tax loophole in the capital gains tax law. The law is known as the 2008 Housing and Economic Recovery act. The law was put into effect as a means of preventing wealthy homeowners from avoiding paying taxes. Prior to the loophole being closed, wealthy home owners who own two or more homes were able to jump from one home to another to avoid paying capital gains.
These wealthy homeowners would avoid paying the capital gains tax by selling their primary home, claiming a full tax exclusion and then moving to a second or third home that they have owned for some time. They would then make it their primary residence and then turn around and sell the home paying little or no capital gains tax.
The modification in the law says that the gain may not be excluded for periods of “non qualified use”, essentially the period of time when the home was not used as the taxpayer’s primary residence.
Special Provisions for Extenuating Circumstances
The military tax exclusion – Being in the military has it’s benefits when it comes to capital gains and selling a home. Because of being deployed, those in the military often find it hard to meet the residency rules and end up paying taxes when they sell. A law put in place in 2003 exempts military personnel from the two-year use requirement mentioned above for up to 10 years, letting a service man or woman qualify for the full exclusion whenever they must move to fulfill their service commitments. There are also additional tax benefits for being a veteran that should be understood. Here is an outstanding reference on property tax exemptions by state for veterans. If you qualify for one of the exemptions it means less money coming out of your pocket!
Your spouse passes away – Another provision in the tax law was changed in 2008. This change takes into account the special circumstance an owner faces when a home after their spouse dies. Previously in order to exclude the full profit amount excluded from taxes the surviving spouse had to sell within the same year of the death. The change allowed the widower to have up to two years to sell the property without facing the burden of paying taxes. As long as the surviving spouse sells withing the two year window they will be able to exclude the full amount of profit.
Understand The Actual Exclusion Amount
The way you figure out how much you can exclude is not just a matter of your sale price. You have to figure out exactly how much profit you made, minus what you put into the home. Profit is what is taxed, and profit is considered how much you made after your basis in the home is accounted for. The equation is not that complicated, but it does involve more than just the final sale price of your home.
To determine your basis in the house, you need to look at what you paid for the home, plus any capital improvements you made to the residence. Capital improvements can be the bathroom renovation, the garage you converted into a recreation room, etc.
One thing to make note of is the importance of distinguishing between an improvement and a repair for tax purposes. Improvements are allowed to count toward your tax basis, repairs are not. Understanding the difference between the two is paramount.
According to the internal revenue service an improvement increases the value of your home while a non-eligible repair just returns something back to it’s original condition. The IRS says that a capital improvement has to last for more than one year, add value to your home or prolong it’s life. The perfect example to distinguish between the two would be fixing a window pain vs installing replacement windows.
This is why it’s always a good idea to keep receipts from any improvements you make to your house. It all matters when you are calculating your basis. Once you know what you have invested, then you can subtract that number from the sale price of the home to get your actual profit.
Keep in mind that even if you do not meet the exact standards for the exclusion – say you lived there only a year and a half – you can still use a portion of it to protect your profits. The exact amount will be based on how closely you do fit the standards. At a year and a half, you would be at 75% of the requirement, meaning you could get a 75% exclusion.
If you are considering selling your house, talk to your Realtor and your accountant to determine exactly how these laws apply to you. If you are like most people, you can sell your home without worrying about taxes. The IRS also puts out a great real estate tax guide that can help answer questions you may have as it pertains to taxes.
The information contained in this article is believed to be accurate, however every person’s individual tax situation may be different, therefore before acting on the information contained herein, you should consult a qualified tax accountant or attorney.
Call Justin Thayer @ 541-543-7287