U.S. tax laws have long offered incentives to people who own the homes they live in. Among the most generous of these incentives is the ability to reduce the taxable gain on the sale of a personal residence. Here’s what most sellers need to know to meet the requirements of the law.
Are You Eligible for Exclusion?
When it comes time to sell a house, the capital gains exclusion provisions are relatively straightforward. If they meet the IRS’s eligibility test (see below), married couples filing a joint return can exclude up to $500,000 in gain, and single taxpayers can exclude up to $250,000. Most taxpayers qualify for the full exclusion by meeting these criteria in the eligibility test:
- Ownership — You meet this requirement if you have owned the home for at least 24 months out of the last five years leading up to the date of the sale (closing date). A married couple filing jointly satisfies this test if at least one spouse meets the ownership requirement.
- Residence — You meet this requirement if you owned the home and used it as your residence for at least 24 months of the previous five years. Unlike with ownership, both spouses must meet this requirement.
- Look-back — You may take the home sale exclusion only once during a two-year period. If you excluded the capital gain generated by the sale of another home during the two-year period before the sale date (closing date) of the current home, you cannot exclude the gain on this sale.
If you don’t meet the criteria for full exclusion listed above, the law may still allow you a partial exclusion of gain if you are forced to sell your home for certain reasons. You should consult with a tax professional about possible partial exclusions if your home sale is the result of one of the following:
- A work-related move
- A health-related move
- Unforeseeable circumstances, such as the destruction of your home, death of a spouse, or loss of income
How Much Gain Do You Have?
Much of your tax benefit is determined based on your original purchase price and the improvements you’ve made over the years. The capital gains tax exclusion for home sale proceeds starts with the calculation of your “tax basis” in the house. Your basis will be the original purchase price plus the costs of substantial improvements. There are no bright-line dollar figures to define “substantial improvements,” but common sense will guide most taxpayers to the right answer. For instance:
- Substantial improvement: You gut your kitchen and replace the appliances, cabinets, sink, and countertops.
- Not a substantial improvement: You replace a leaky faucet and a garbage disposal.
Some selling expenses can also be deducted from the sales price when determining gain, including advertising expenses, closing fees, document preparation fees, and title search fees, just to name a few.
Watch Out for Depreciation Deduction Recapture
Keep in mind that if you had reason to take a depreciation deduction on your return during the time you owned the house — for instance, if you used a portion of the house as a home office or if you rented it out for a period of time — the tax law will require you to “recapture” those amounts when you sell. This provision sometimes results in an unexpected tax bill at a time when taxpayers thought they had taken all necessary steps to exclude gain.
Plan Ahead to Avoid Tax Surprises
Most people start the process of selling their home by finding a good realtor. That’s definitely an important early step, but a knowledgeable tax professional should also be high on the list of advisors you need to see. The tax law provides a fairly generous exclusion for home sales, but failure to meet the specific requirements can be costly and hard to remedy. Solid tax planning can help you avoid any unfortunate surprises. Be sure to reach out to your local CRI tax advisor if you have any questions about how tax laws will affect the sale of your home.