When it come to the IRS and taxes; nothing is ever simple. The same is true of real estate capital gains.
Capital gain on the sale of your primary home is the difference between the price you paid and the price you sell it. So, if you bought your home for $250,000 in 2012 and sell today for $500,000, you will have a gain of $250,000. However, depending on your particular circumstances, you may not owe taxes on the gain.
The Tax Payer Relief Act of 1997 (TPA)
The IRS will allow you to exclude up to $250,000 of the gain for a single filer ($500,000 on a joint return with a spouse). Click on eligibility requirements to read the IRS rules.
Generally, there are two tests; the ownership test and use test. You must have owned and used your home as your primary residence for 2 out of the 5 years prior to the sale. You can’t use the exclusion if you have taken the exclusion within the previous two years on the sale of another property. You do not have to report the sale on your taxes if all of the gain is excluded.
Ownership & Marital Status
The exemption is straight forward for couples married with joint ownership and occupying the home for two years of the previous 5 years before the sale.
A recently married couple who have lived in the home together for two years but the spouse was only added to the title a few months before the sale are also allowed to take the $500k exemption as long as one of the individuals did not sell property within two years and take the exemption. Both spouses do not have to be on the title for the full two year period but both must have used the home as a primary residence for the full two year period.
All Sales Are Not Equal
Rental property and second homes are not treated the same as your primary residence. However, if you convert a second home to your primary home, then you can get a prorated exemption based on the time it was a rental and your primary residence.
If you purchase real estate to fix and re-sell, as a “real estate flipper”, you do not qualify for the exemption and all your gains are taxable.
The capital gain tax rate is 15% for most folks and 20% for the top tax brackets. A tax free 1031 exchange can be used to postpone taxes on investment property.
For higher income tax payers (adjusted gross income over $200k or $250k for married joint filing couples), there’s potentially a 3.8% Medicare surtax on capital gains under Obama Care rules.
If you made major improvements to the home, the amount can be used to adjust your basis together with your purchase price to reduce your gain. Generally these are improvements with a useful life of more than a year, or that increase the value, lengthen its life, or adapt it to a different use. See IRS Publication 523 for a list of qualifying improvements. You should always keep your receipts and records of any improvements made to the home over the course of your ownership for this reason.
The rules for items considered capital improvements can be a little tricky. For example, replacing a broken window pane is considered maintenance while replacing windows for the home is considered a capital improvement.
Painting, replacing appliances or planting annual flowers are generally considered maintenance and are not capital improvements. Adding a detached garage, replacing the roof or adding new HVAC would be an example of a capital improvements.
Lawyer Fees and Real Estate Commissions
The real estate commission paid by sellers for their primary residence is not deductible but can be added to your basis as the cost of the sale. Lawyer fees are not deductible. Fees for tax advice and preparation are deductible if you itemize your deductions and meet the 2% minimum for miscellaneous deductions.
For vacation rentals or property flippers, commission and legal fees would be deductible costs.
If you need to sell a home due to special circumstances, like a change in health, employment or other circumstances, you may still be able to take a prorated reduction based on the amount of time you spent in the home for the prior two years. So, if you need to move for employment reasons and only lived in the home for 1.5 years, then this is 75% of the two year period. You would still qualify for $187.5K exemption (.75 x $250,000).
Special rules apply to members of the military due to deployments and service commitments that make it more difficult to pass the use test and allows them 10 years in which to do so.
Tread carefully when taking a home office depreciation deduction. All the depreciation deductions taken on your home will be subject to a higher tax, at 25% when you go to sell the home. For example, if your adjusted basis is $250,000 and you have taken depreciation of $50,000 and sell for $500,000 then only $200,000 of your gain is excluded and $50,000 will be subject to the 25% tax.
Tax planning and preparation can be complicated. It is always best to consult with an expert in this area for specific advice that considers your exact circumstances. The Eillu team has decades of experience selling real estate on the Outer Banks and have insight to structure 1031 exchanges and more complicated deals. Schedule an appointment today to learn how to maximize the profit on the sale of your home with our low real estate listing commission.