For most people, the home sale gain exclusion is the biggest tax break they'll ever get. But the exclusion is subject to several complicated rules and limitations, so it's important to plan carefully before you sell to shield as much of your profit from tax as possible.
Normally, when you sell appreciated real estate or other capital assets you've held for more than one year, your gains are subject to capital gains taxes at a rate of 15% or 20% (depending on your tax bracket). If your income is high enough, you may also be subject to an additional 3.8% net investment income tax. So, a high-income taxpayer who sells real estate for a $250,000 profit would potentially be liable for $59,500 in taxes ($250,000 x 23.8%).
Fortunately, the tax code offers a generous tax exclusion for gain from the sale of your principal residence. The exclusion allows single filers to avoid taxes on up to $250,000 in gain. For married couples filing jointly, the exclusion is doubled, to $500,000.
If you're planning to sell your principal residence, don't assume that you automatically qualify for the exclusion — check to be sure you meet the eligibility requirements. If you're single, you must have owned the home and used it as your principal residence for at least 24 months of the five-year period preceding the sale.
If you're a married couple filing jointly, then at least one of you must have owned the home for at least 24 months of the preceding five years and both of you must have used it as your principal residence for at least 24 months of the preceding five years. Technically, two different homes could meet these requirements at the same time, but you're not permitted to claim the exclusion more than once in a two-year period.
The eligibility rules get more complicated for couples who are separated or divorced, homeowners who move to nursing homes, and military personnel. Also, if work or health circumstances require you to move before you meet the 24-month threshold, you may qualify for a partial exclusion. Be sure to consult your tax advisor if any of these situations apply to you.
Special rules apply to the conversion of an ineligible residence into a principal residence. Suppose you and your spouse have owned a home for 10 years and have used it as a rental property for six years and as your principal residence for the past four years. If you sell the home for a $500,000 profit, only 40% of that amount (4/10) is eligible for the exclusion. That means $200,000 in gain is excluded and the remaining $300,000 is taxable.
It's important to keep track of home improvements. Your gain on the sale of a home is generally equal to the selling price minus your cost basis, which is the purchase price plus or minus certain adjustments. Some home improvements (for example, an addition or a kitchen remodel) may increase your basis, thereby reducing your gain. So, it's critical to document these expenses.
In addition, if your spouse dies, you can still claim the full $500,000 exclusion if you sell your principal residence within two years and haven't remarried. Be aware, however, that if you and your spouse owned the home jointly, you'll be entitled to significant tax benefits regardless of when you sell. That's because your spouse's share of the home's value receives a "stepped-up" cost basis. In some community property states, the full value of the home gets a step-up.
Before you sell your principal residence, be sure you understand the tax implications. Calculate your expected gain (selling price minus adjusted cost basis) and determine the amount of your home sale gain exclusion. Your tax advisor can help you navigate the ins and outs and ensure you obtain the proper exclusion amount for your circumstances.
If you have a home office, be sure you understand its impact on your tax bill when you sell your home. If the office is located within your home, you need not allocate your gain between the personal and business portions. In other words, you can claim the home sale gain exclusion for your entire gain. But if the office is outside your home — for example, in an unattached garage, guesthouse or other structure — you'll have to allocate your gain between the home and office. You'll then pay taxes on the gain attributable to the office.
Regardless of the office's location, however — and regardless of the amount of your home sale gain exclusion — your gain will be taxable to the extent you deducted depreciation of your home (after May 6, 1997) as part of a home office deduction. These "recaptured" depreciation deductions are taxed at ordinary income tax rates, with a 25% maximum. Note: This deduction currently applies only to business owners or the self-employed. Employees don't qualify for the home office deduction because the miscellaneous itemized deduction was suspended under the 2017 Tax Cuts and Jobs Act. Keep in mind, though, that prior depreciation — that is, any amount taken before the law change — still has to be considered.
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