What would you do with an additional $250,000 or $500,000 of tax-free income? Selling your home at a gain is one of the few ways the IRS allows you to make money without paying tax. To take advantage of this bonus, you need to time the sale correctly.
A single person can exclude $250,000 of gain on the sale of a personal residence, and a couple filing as Married Filing Joint can exclude $500,000 of gain. A home can be a boat, a recreational vehicle, a trailer, or a condominium.
Gain is calculated as the selling price minus expenses of the sale minus the adjusted basis of the house. The adjusted basis equals the original cost plus improvements. If you have a home office or used part of your home for business, or if you’ve rented your home to others, your basis will be reduced by any depreciation you deducted.
Normal repairs and maintenance don’t count as improvements, but if you replace the roof, install new windows or doors, add central air conditioning or build an addition, those costs can be added to the basis.
Any gain you recognize will be taxed at capital gains rates, which are currently 0%, 15% or 20%, depending on your overall AGI. If your income is above the threshold for the net investment income tax, you’ll have to pay an additional 3.8% on your recognized gain.
To qualify for a gain exclusion, you need to pass three tests:
1. Ownership: you must have owned the home for two of the previous five years.
2. Use: you must have used this home as your principal residence for two of the previous five years.
3. One sale in two years: you can only exclude the gain from the sale of a home once every two years.
If you own more than one home, your principal residence will generally be the place where you spend the majority of your time. However, the IRS has also considered proximity to work and to the homes of other family members as well as addresses on tax returns, driver’s licenses, voter registrations, bank accounts and bills in their determination of principal residence.
Members of the military or intelligence community and foreign service personnel who serve extended duty at least 50 miles from their homes can elect to suspend the five-year test for up to ten years.
Partial gain exclusion allowed
If you can’t pass the three tests for the maximum gain exclusion, you may still qualify for a partial exclusion. The IRS allows partial exclusions if you sell your house due to a change in employment, for health reasons or because of unforeseen circumstances. Examples of unforeseen circumstances include natural disasters, death, divorce, loss of a job, and multiple births from a single pregnancy.
Renting your house affects the gain you recognize
If you move out of your home and rent it before selling it, and you pass all three of the above tests, you’ll still qualify for the maximum gain exclusion, but any depreciation you previously deducted will be recognized as a gain.
However, if you own a rental house and then convert it to your personal residence before selling it, you may have to allocate the gain between the periods of use as a rental and as your home.
A home office can also impact your recognized gain
If you claimed depreciation deductions on your home because you had a home office, any depreciation after May 6, 1997, will be recognized as a gain. As long as you meet the other three tests, you can still exclude the remaining gain on the sale.
With some careful planning, selling your home can be profitable and tax-free. Complex situations may require additional analysis to get you the maximum gain exclusion.
If you’re considering selling your home, or if you’ve already sold your home, please call our office at 561-624-2118 to discuss it with us.