Despite a bit of a slowdown, the residential real estate market is still hot, and if you’re like most homeowners these days, your property has likely gone up in value since you purchased it.
Eventually, when you sell your home, you’ll need to determine the income tax consequences with respect to that built-in appreciation.
Many homeowners are aware of the general tax rule for home sales. If you have owned and lived in your main home for at least two out of the five years leading up to the sale, up to $250,000 ($500,000 for couples filing a joint tax return) of your gain is tax-free. Any excess gain is taxed at long-term capital gains rates, which range from 0% to 23.8%, depending on your taxable income. Losses from sales of primary homes are not deductible.
Say you’re married, bought your home in 1995, have a tax basis of $150,000, and are selling the home this year for $500,000. The entire $350,000 of gain is tax-free. Take the same example, except you sell the home for $775,000. The first $500,000 of the gain is tax-free, and the remaining $125,000 is taxed at long-term capital gains rates.
To determine your gain or loss from your home sale, start with the amount of gross proceeds reported in Box 2 of Form 1099-S and subtract selling expenses, such as commissions, to arrive at the amount realized.
You then reduce that figure by your tax basis in your home. To figure your tax basis, start with the original cost, add certain settlement fees and closing costs, plus the cost of any additions as well as improvements that add to the value of your home, prolong its useful life or adapt it to new uses.
If you must sell your home before meeting the two-out-of-five-year use and ownership tests, you may still be eligible for a portion of the $250,000/$500,000 exclusion, depending on the circumstances. Sales due to job changes, illness or other unforeseen circumstances qualify.
The percentage of the exclusion that you are eligible for is equal to the portion of the two-year period that you used the home as a residence.
Say a single person bought a home for $450,000 in April 2021, lived in it for 18 months and sold it in September 2022 for $520,000 after moving out of state for a job.
The maximum gain exclusion here is $187,500 ($250,000 x (18/24)); so, the full $70,000 gain is tax-free. You can use days or months for this calculation.
Vacation Home Converted to Primary Home
If you convert a vacation home to your primary residence, live there for at least two years and then sell it, you may not get the full home sale exclusion. The portion of the gain that is not eligible for the $250,000/ $500,000 exclusion, and is thus otherwise taxed, is based on the ratio of the period of time after 2008 that the home was used as a second residence or rented out to the total time that the seller owned the house.
The remaining gain is eligible for the exclusion.
Selling a Home Soon After the Death of a Spouse
A spouse who sells the family home within two years after the death of the other spouse gets the full $500,000 exclusion that is generally available only to couples, provided the 2-out-of-5-year ownership and use test was met before death.
There is also a welcome added tax benefit if you owned the home jointly with your spouse. If you don’t live in a community property state, half of the home will get a step-up in tax basis upon the death of the first-to-die spouse. The rule is more generous if the house is held as community property. The entire tax basis is stepped up to fair market value when the first spouse dies. Here’s an example. Let’s say you and your spouse bought a home for $100,000 many years ago in a non-community property state, and it is worth $950,000 on the date the first of you dies. The survivor’s tax basis in the home jumps to $525,000 (his or her half of the original $100,000 basis plus half of the deceased spouse’s $950,000 date-ofdeath value). Twenty months later, the surviving spouse sells the home for $995,000. The full $470,000 of gain ($995,000 - $525,000) is tax-free
Joy is an experienced CPA and tax attorney with an L.L.M. in Taxation from New York University School of Law. After many years working for big law and accounting firms, Joy saw the light and now puts her education, legal experience and in-depth knowledge of federal tax law to use writing for Kiplinger. She writes and edits The Kiplinger Tax Letter and contributes federal tax and retirement stories to kiplinger.com and Kiplinger’s Retirement Report. Her articles have been picked up by the Washington Post and other media outlets. Joy has also appeared as a tax expert in newspapers, on television and on radio discussing federal tax developments.
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