For many people, their homes are their greatest assets—ones that they might plan on selling someday to relocate to another part of the country, upgrade to a larger home or help finance retirement. Unless you've sold a home over the past few years, you may not realize that revisions in the tax code could impact how much you end up with after the sale. Learn how the newest tax laws will affect you if you decide to move.
The Old Rules
In the past, sellers could defer capital gains taxes on all past profits, no matter how large, as long as they met the following two requirements:
- Purchased a replacement home that costs more than the amount received for the home that was sold.
- Purchased the replacement within two years before or two years after the date of the sale.
For instance, suppose you had bought a home for $200,000 and sold it in five years for $300,000. As long as you had purchased another one within two years for at least $300,000, you could have avoided capital gains tax on the $100,000 profit. Furthermore, you could have continued this process every year, potentially building an unlimited amount of tax-deferred gains. Then when you died, the gain could have been wiped out because of the step-up in basis provision for your beneficiaries.
In addition, a seller who had reached age 55 could permanently exclude up to $125,000 in profits without buying another home.
The New Regulations
On August 5, 1997, the Taxpayer Relief Act of 1997 took effect. The act did away with the continual unlimited deferral of profits and replaced it with capped exclusions.
Single taxpayers can now exclude up to $250,000 in profits on their home's sale. Married couples who file jointly can exclude $500,000 from their taxable income. Age is not a factor and you do not have to buy a replacement home. After you take the exclusion, you could buy a less expensive home or even rent one. Better still, the IRS will let you use the exclusion each time you sell your primary residence.
There are two rules:
- You must have owned and used the home as your primary residence for at least two out of the previous five years.
- You cannot have used the exclusion during the preceding two years.
For example, suppose that a married couple had bought their home eight years ago for $200,000 and lived in it during that time. Now they're ready to sell for $450,000 and move to a larger home that costs $400,000 in a less expensive part of the country to accommodate their expanding family. Because of the exclusion, they will not have to pay capital gains tax on the $250,000 profit.
Let's look 20 years in the future when our couple wants to retire and downsize to a condo. They sell their large home for $1 million and buy a condo for $750,000. They will have a $600,000 capital gain ($1 million – $400,000) on the house sale. However, they will only have to pay tax on $100,000 of profit because of the $500,000 exclusion. They can use the $250,000 in cash that remains after they buy the condo any way they wish.
The required two years of ownership and use during the five-year period ending on the date of sale do not have to be continuous. Therefore, if you rented out your home during the first, third and fifth year of ownership but lived in it for the second and fourth years, you could still take the exclusion.
Furthermore, there are exceptions to the two-year occupancy rule. These include: disability, condemnation, and divorce.
If the exclusion wipes out all of your gain, you don't have to report the sale on your tax return. Otherwise, you must file the transaction on Schedule D. In either case, be sure to keep all records for at least three years.
Don't think you can only use this exclusion if you own a single family, traditional house. The act applies to any dwelling that you consider your primary residence, such as a:
- Condo or townhouse
- Cooperative apartment
- Mobile home
How to Reduce the Tax
Although avoiding tax on a $250,000 ($500,000 for joint tax filers) profit is significant, it might not be enough to totally offset some sellers' gains. There are a few things you can do to increase your cost basis and reduce your tax liability.
Go back through your records to find out if you had other allowed expenses, including:
- Settlement fees or closing costs when you bought the home
- Real estate taxes that the seller owed but for which you paid and were not reimbursed
- Home improvements, such as a new roof or room addition
The Bottom Line
Finally, look at your other investments. Do you own stocks, bonds or other real estate that are worth less than you paid for them? You could sell those and use the losses to offset the capital gain on the home sale.