Real estate, in the form of the home you live in, is one of the most common investments that people make. Like any other investment, when a home is sold, you may be liable for tax on any profit made. This tax is known as the capital gains tax.
Many people can reduce or avoid capital gains tax because of an IRS rule that allows you to exclude some of the gain from your taxable income. In addition, improvements you have made to the property also play a role in reducing the capital gain.
(Note: The sale of a rental property, however, is a completely different situation with a complex set of rules and few of the factors below apply.)
Home Sale Gain Exclusion
The main source of reducing capital gains tax on the sale of a home is the IRS home sale gain exclusion rule – the “Section 21 exclusion” — which allows you to avoid paying tax on a gain up to $250,000 for a single taxpayer or $500,000 for a married couple filing jointly. You can take advantage of the exclusion over and over during your lifetime, but not more frequently than every 24 months, as long as you meet certain ownership and use tests.
During the five-year period ending on the date of the sale, you must have owned the home for at least two years, the Ownership Test. You must have lived in the home as your main home for at least two years, the Use Test. And you must not have excluded the gain from the sale of another home during the two-year period ending on the date of the sale.
The Ownership and Use periods need not be concurrent. Two years means 24 months or 730 days within a five-year period, but the months or days do not have to be consecutive. Short absences, such as for a summer vacation, count in the period of use. But longer breaks, such as a one-year sabbatical, are not counted.
If you are married and file taxes jointly, only one of you needs to meet the Ownership test. Also, people who are disabled, who needed outpatient care, or are in the military may be able to get exceptions to the Use test.
If you own more than one home, you can exclude the gain only on your primary home. The IRS considers a number of factors to determine which home is the principal residence. Indicating the address as your primary home address on as many of the following documents is beneficial:
• Place of employment records
• Documentation related to location of family members’ main home
• Mailing address on bills and correspondence
• Tax returns
• Driver’s license
• Car registration
• Voter registration
• Local bank records
• Local recreational clubs and religious organization memberships
The exclusion can be used repeatedly every time you reestablish your primary residence. Unfortunately, if you experience a loss instead of a profit on the sale of your main home, the loss is not tax deductible, with one exception; If a portion of your home is rented out or used exclusively for business, the loss attributable to that portion of your home may be deductible, subject to various limitations.
Improvements to the Home
The second source of reducing capital gains tax is the cost of any improvements you have made to the home. These costs will increase the “basis” of the home. The basis is simply what you originally paid for the home, plus the cost for any improvements. The profit that could be subject to capital gains tax is the amount that you sell the home for, minus the basis.
Improvements are considered anything that has a useful life of more than one year and may include:
• Building an addition
• Finishing a basement
• Putting in a new fence or swimming pool
• Paving the driveway
• Landscaping or installing new wiring, new plumbing, central air conditioning, flooring, insulation, or a security system
All such improvements made to the home over the years will increase the home’s basis. Items considered ordinary repairs and maintenance such as painting, cleaning or any other improvement that is not part of a larger project and does not extend the life of the related asset, will not increase the basis.
Many costs in selling the home such as commissions, advertising, and legal fees are also added to the basis to reduce the capital gain.
Exclusion Rules
Even if you do not meet the ownership and use tests, there are circumstances when you may be allowed to exclude a portion of the capital gain realized on the sale of your home. Partial exclusions may apply if you sell your home because of health reasons, a change in place of employment, or unforeseen circumstances like a divorce or natural or man-made disasters that result in a casualty loss to your home.
Capital Gains Tax Rates
If you do owe capital gains tax on the sale of your home, two different tax rates may apply. The short-term rate applies if you owned the house for a year or less, and is equal to your ordinary income tax rate. Long-term rates apply if you owned the home for more than a year, and are generally lower than the short-term rate, depending on filing status and income.
Recordkeeping
In general, tax records should be kept for three years after the tax filing due date. However, you should keep documents related to your home’s cost basis for as long as you own your home. The records should include proof of the home’s purchase price and the purchase expenses as well as receipts and other records for all improvements that affect the home’s cost basis.
If you have questions about this featured topic or other accounting and tax related topics, please do not hesitate to contact us at 727-327-1999 OR [email protected].
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.
