One of life’s major stressors can be the sale of a home. If you haven’t had the pleasure of keeping your house immaculate for potential buyers to roam through (sometimes at a moment’s notice) consider yourself lucky. On one ranking of the ‘top 40’ stress list, selling a residence comes in at about number 32. Those of us who have been through the process might be more likely to rate it in the ‘top 10’!
Wherever the process ranks in terms of the level of stress you’re feeling, it certainly can be a hassle. There are, however, a few good tax breaks that could reduce that level quite a bit.
To begin with, let’s take a look at the rules about recognizing (or not recognizing) a gain on the sale of your home. As a general rule, you can exclude up to $250,000 ($500,000 if you are married filing jointly) of any gain on the sale of your primary residence. The calculation of the gain is rather simple: you take the sales price of your home, less any expenses (like commissions, closing costs, etc.) and subtract your basis in the home. The basis is the amount you originally paid for the home, including closing costs, plus the costs of any improvements.
Well, okay, that was simple - but a simple tax law is an oxymoron! The first hitch to ‘the simple way’ is that you must have lived in the home for two out of the last five years. Under normal circumstances, this particular legal wrinkle is not that difficult to meet - the average person resides in their home for about 7 years.
As it turns out, however, there are actually a good number of people who move before living in their home for two years. For this reason, Congress provided some exceptions to the general rule. If you do move before meeting the two-year requirement because of a change in employment, a change in health, or "unforeseen circumstances," you can qualify to exclude a portion of the $250,000 exemption. Example: you move after living in your home for 12 months, so you would divide 12 by 24 months and multiply it by $250,000.
For taxpayers who become physically or mentally unable to care for themselves, after living in their home for at least one year, the period of time during which they stay in a nursing home will be counted as if they had lived in their own home. Say your elderly relative lives in their home for one year, then must be moved to a nursing home. After residing in that care facility for one year, the two year requirement will have been met.
Do you use part of your home for business purposes? At one time, the business use of your home would cause major headaches, but the gain recognition law is very simple now. Say you use a room in your home as an office and you deduct $10,000 of depreciation as a home office deduction. If you sell the home for a $250,000 gain, all you will be required to include in income is the $10,000 in depreciation you deducted. Note: at one time, you would have been required to recognize a pro-rata portion of the gain in income.
Let’s switch gears a moment and assume you moved from a previous residence two years ago and turned it into a rental property. Common sense would lead you to believe that, if you sell the home for a gain, the whole gain is taxable. After all, you are then selling a business asset, not your home.
The good news is that, if you meet the two-out-of-five-year primary residence requirement, you can exclude the portion of the gain that isn’t attributable to depreciation. Home builders often build a home, live in it for two years, and then sell it to realize a non-taxable gain.
What we have discussed in this article are some guidelines - and major exceptions - to recognizing gains on the sale of a primary residence. There are also some exceptions that apply in limited circumstances, and even some of those we’ve discussed have a few quirks that could trip you up. In addition, people in the process of divorce need to be careful how and when they sell a marital home. In order to prevent turning a tax-free gain into a taxable one, it’s wise to discuss your situation with your financial planner or CPA. Don’t have a CPA? Give us a call. We’ll be glad to help.
Have a great St. Patrick’s Day.
