It’s smart to understand your potential capital gains tax liability before you put your house on the market.
Reduce Your Capital Gain Tax
Homeowners can exclude up to $250,000 of capital gain from tax. For married couples filing jointly, the exclusion is $500,000, and unmarried couples who jointly own a home and separately meet the ownership and use test may also exclude up to $250,000. This test requires that in order to claim the entire exclusion, you must have owned and lived in your home as your principal residence of at least two of the five years before the sale. You can claim the exclusion once every two years. Generally, you are not eligible for the exclusion if you excluded the gain from the sale of another home during the two-year period prior to the sale of your home. But, even if you don’t meet this test, you still may be entitled to a whole or partial tax break in certain circumstances.
If You Don’t Meet the Use Test
Now let’s say that you still have some capital gains that don’t seem to fall under the exclusion. Even if you haven’t lived in your home a total of two years out of the last five, you’re still eligible for a partial exclusion of capital gains if you sold because of a change in your employment, or because your doctor recommended the move for your health, or if you’re selling it during a divorce or due to other unforeseen circumstances such as a death in the family or multiple births. (‘I changed my mind about living here’ won’t cut it.) In such a case, you’d get a portion of the exclusion, based on the portion of the two-year period you lived there. To calculate it, take the number of months you lived there before the sale and divide it by 24. For example, if an unmarried taxpayer lives in her home for 12 months, and then sells it for a $100,000 profit due to an unforeseen circumstance, the entire amount could be excluded. Because she lived in the house for half of the two-year period, she could claim half of the exclusion, or $125,000.
Know the Meaning of Important Terminology
For many prospective home buyers and sellers, the language of a real estate contract is an indecipherable document best left to the real estate professionals – as long as at the end of the transaction a check and a key change hands. For instance, some sellers mistakenly believe that their gain is simply the profit on the sale. It’s not so simple, but knowing the meaning of the fine print and real estate and financial terminology – and what it means for you – works to your benefit. Your gain is actually your home’s selling price, minus deductible closing costs, selling costs, and your ‘tax basis in the property.’ The basis is the original purchase price, plus purchase expenses, plus the cost of capital improvements, minus any depreciation and minus any casualty losses or insurance payments. Deductible closing costs include points or prepaid interest on your mortgage and your share of the prorated property taxes. Examples of selling costs include real estate broker’s commissions, title search and insurance, legal fees, administrative costs, escrow and inspection fees.
So, for example, if you and your spouse bought a house for $100,000 and sold for $650,000, but you’d added $20,000 in home improvements, spent $5,000 fixing the place up for the sale, and paid the real estate brokers at least $25,000, the exclusion plus those costs would mean you’d owe no capital gains tax at all.
Marriage and Divorce
Married couples filing jointly may exclude up to $500,000 in gain, provided:
• Either spouse owned the residence
• Both spouses meet the criteria for the ownership and use test, and
• Neither spouse has sold a residence within the last two years.
Separate residences. If each member of a married couple owns and occupies a separate residence and files jointly, each may exclude up to $250,000 in gain when they sell. Also, if it’s a new marriage and one spouse sold a residence within two years before the marriage (thereby disqualifying him, or herself, from the exclusion), the other spouse may still exclude up to $250,000 in gain on a residence owned before the marriage. A new marriage may also double the tax break in some circumstances. Suppose a single man sold his principal residence on October 1 and gained $500,000 in profits. Let’s also say that he and his girlfriend had been living in the house for two years (but her name wasn’t on the title), so they both satisfy the use test. If they get married by midnight on December 31 of the same year, they can file a joint return for that year and exclude the entire $500,000.
Divorce and the Tax Break
Divorced taxpayers may tack on the ownership and use of their residence by their former spouse. For example, say that upon divorce, the wife is allowed to live in the husband’s residence until she sells it. He has owned the residence for 18 months. Once the sale occurs, the couple will split the profits 50-50.
If the wife sells the home nine months later, she may include her ex-husband’s ownership to meet the two-year ownership test. Also, the husband may tack on his ex-wife’s continued use of the residence to meet the two-year use test. Each one is entitled to exclude $250,000 of profits from the sale. Widowed taxpayers may also tack on the ownership and use by their deceased spouse.
Home Offices: A Tax Drawback
The exclusion does not apply to depreciation allowable on residences after May 6, 1997. If you are in a high tax bracket and plan to live in your home for a long time, taking depreciation deductions for a home office is quite valuable right now. But if not, you might want to reconsider using a portion of your home as an office, because all depreciation deductions you take will be taxed at 25% when you sell the house. For instance, if a married couple sells a home with an adjusted basis (purchase price plus capital improvements) of $100,000 for $600,000. Over the years, they had taken $50,000 in depreciation deductions for a home office.
Sales Price: $600,000
Adjusted Basis – $100,000
Taxable gain = $500,000
Of that gain, $450,000 is tax-free; the $50,000 taken as depreciation deductions is subject to 25.
Cutting down on Tax Fraud: Home sales must now be reported to the I.R.S. on Form 1099S soon after the closing. The information can then be cross-checked against individual tax returns. Some lawyers, escrow agents, real estate brokers and others who handle real estate transactions charge sellers fees ranging from $50 to $200 to file a 1099S. The tax law, however, prohibits any charge for the filing.
For more information, see IRS Publication 551, Basis of Assets, and look for the section on real property or visit http://www.irs.gov/taxtopics/tc701.html for more information.