Jeffrey G. Olson, CPA, a partner specializing in real estate tax issues at Carr, Riggs, & Ingram CPAs and Advisors, LLC, one of the largest regional accounting, tax and advisory firms in the country, Atlanta. CRICPA.com
Thinking of selling your house? Not surprisingly, the IRS wants its share. Over the past five years, home prices have jumped an average of 9% annually, according to the S&P CoreLogic Case-Shiller US National Home Price Index. The IRS home-sale gain exclusion is a fixed amount and not indexed for inflation. And the surge in housing values means that more home sellers can expect to hand over some of their windfalls to the IRS. Real estate accountant Jeffrey G. Olson, CPA, says you can save tens of thousands of dollars by avoiding these mistakes…
Mistake #1: Not understanding how to calculate capital gains from your home sale. Capital gains are the net profits from selling your house. To calculate your capital gains: Take the original purchase price, or “cost basis,” of your home. Subtract that amount from the final sale price. If that amount is positive, that is your capital gain. The amount of debt you have on the home does not factor into the determination of your gain. Example: If you bought the house for $250,000 and sold it for $1,000,000, your capital gains are $750,000. If you have a capital loss on the sale of any personal-use asset, including your principal residence, that loss is not deductible for income tax purposes.
Bonus: The IRS gives home sellers ways to reduce their taxable capital gains including a special homeowner gain exclusion…allowances for costs involved in the purchase and/or sale of your home (title, escrow, recording fees, real estate agent commissions, etc.)…and allowances for qualifying home improvements. Helpful: IRS Publication 523, Selling Your Home, available at IRS.gov, is a review of the applicable tax rules. The worksheet on page 12 will help you determine the capital gains from your sale.
Mistake #2: Thinking that the old IRS rules about capital gain exclusion apply when selling a home. Home sellers now may be able to exclude the gains on the sale of their homes up to certain dollar limits if they meet certain ownership and use requirements and have not used this principal residence gain exclusion in the past two years. They do not need to also reinvest the sale proceeds in a replacement home (the IRS replaced that rule in the late 1990s). For singles or married persons filing separately, the maximum gain exclusion is $250,000…for married couples filing jointly, generally $500,000. Basic example: You purchased a house 10 years ago for $300,000 and sold it for $600,000, for a capital gain of $300,000. If you are married and qualify for the maximum gain exclusion of $500,000, you owe no capital gains tax. But if you’re single and qualify for the maximum exclusion, you owe tax but only on the $50,000 of gain that exceeds your $250,000 exclusion.
Mistake #3: Not meeting qualifications for the home-sale exclusion. The government wants to discourage business speculators from buying a home, moving into it as their primary residence, quickly flipping it for a profit and then claiming a gain exclusion. To qualify for the full gain exclusion…
You must have owned and lived in the home as your principal residence for at least two of the last five years immediately preceding the sale. The two years do not have to be one concurrent period.
The home must be your principal residence, not a secondary or vacation home. “Principal residence” generally is defined as the address where you spend most of your time and that is listed on documents such as your federal and state tax returns, voter registration card and driver’s license. Smart strategy: If you have a greatly appreciated vacation home that you want to sell, move into it for two years before you sell it so that it qualifies as your principal residence. Then move back to your other home for another two-year period to remake it your principal residence.
You cannot claim the home sale exclusion more than once in any two-year period.
For a married couple filing jointly: Either spouse (or both) can own the home in terms of legal title, but each spouse must separately meet both the two-out-of-the-last-five-year usage requirement…and have not used the IRC 121 gain exclusion in the last two years. It may be tricky for each spouse in a newly married couple to meet these requirements.
Reduced gain exclusions: If you fail the two-year-use test or used the gain exclusion in the last two years, all is not lost if the reason for the home sale was due to unexpected circumstances, such as a change in marital status or employment. Consult a tax advisor—you may qualify for a reduced gain exclusion.
Exceptions to the general capital gain exclusion requirements: A surviving spouse’s exclusion is $500,000 if he/she sells the home within two years of a spouse’s death and the survivng spouse has not remarried at the time of the sale. For those who are sick and/or elderly and resided in their home for at least 12 months of the last five years, any time spent living in a licensed care facility (such as a nursing home) counts toward the two-year residence requirement.
Mistake #4: Not taking advantage of home-improvement deductions to lower your capital gains. The IRS allows you to add to your property’s “cost basis” the cost of improvements you make to your home that effectively shrink your taxable gain upon sale. In general, improvements are defined as expenses that add to the home’s value, prolong its useful life or adapt it to new uses. Examples: Adding a bedroom, bathroom, hardwood floors, new roof, deck or swimming pool…adding insulation in the attic and walls…upgrading plumbing or heating and air-conditioning systems…kitchen remodels. Improvements must be evident when you sell, so if you put in wall-to-wall carpeting 10 years ago and then replaced it with hardwood floors five years ago, you cannot add the cost of the carpeting to your cost basis.
What doesn’t qualify: Repairs that maintain a home’s good condition without adding value such as painting or replacing roof tiles.
Mistake #5: Failing to consider your annual income in the year you plan to sell your home. If you have any gains subject to tax and you have owned your home for more than one year, you pay long-term capital gains (LTCG) tax rates instead of regular or ordinary income tax rates on the taxable profits from the home sale. Your LTCG rate is determined by your taxable income bracket in the year of the sale and could be one or a combination of 0%, 15% and 20%. For 2023 LTCG rates, see TaxFoundation.org/2023-tax-brackets.
Smart step: Strategic timing of your home sale or other strategies to reduce taxable income in the year of the sale could have a positive impact on your tax burden if you will have sale gains in excess of your IRC 121 gain exclusion.
Mistake #6: Not realizing that some situations can lower the cost basis of your home, thus increasing your risk for a big tax bill. Consult a tax professional for the following more complex issues…
You received certain government subsidies. Example: Energy-efficiency tax credits for making energy improvements in your home (the credit amount is subtracted from your cost basis).
You divided your home into business and residence portions for tax purposes over the years. Example: You had a home business and took depreciation deductions on that part of the principal residence…or rented out portions of or the entire home and took depreciation deductions.
Mistake #7: Not understanding how to calculate capital gains on an inherited house. If you sell a home that you inherited, the IRC 121 gain exclusion does not apply since you would not meet the ownership and use test. But your cost basis is not your family member’s cost basis. It is “stepped up” to the property’s value at the date of your relative’s death, so a sale soon thereafter may not have much gain. However, if you choose to move into the home, you then can use IRC 121 against future appreciation provided that you meet the requirements of IRC 121.