Do you owe taxes when selling your home? Learn how to determine your taxable gain by adjusting your home’s cost basis, factoring in home improvements, and utilizing IRS-approved strategies to maximize your tax benefits.
Profit on Home Sales Can Be Tax-Free
Many home sellers are not required to report the sale of their home to the IRS. However, if your situation requires reporting, understanding how to exclude your profit from taxable income can significantly reduce your tax burden.
Do I Have to Pay Taxes on My Home Sale Profit?
Your tax liability depends on how long you owned and lived in the home and how much profit you made:
- If you owned and lived in the home for at least two of the last five years before the sale, up to $250,000 of profit is tax-free.
- Married couples filing jointly can exclude up to $500,000.
- This exclusion can be used multiple times, as long as you meet the two-out-of-five-year rule and haven’t claimed the exclusion on another home within the past two years.
- If your profit exceeds the $250,000/$500,000 limit, the excess is reported as a capital gain on Schedule D.
Qualifying for the Tax Break
To exclude gains from your home sale, you must meet three criteria:
- Ownership Test: You must have owned the home for at least two of the last five years before selling it.
- Use Test: You must have used the home as your principal residence for at least two of the last five years.
- Timing Test: You must not have excluded gain on another home sale within the two years prior to this sale.
For married couples:
- You must file a joint return to claim the $500,000 exclusion.
- At least one spouse must meet the ownership requirement.
- Both spouses must meet the use requirement.
Special Circumstances Allowing Full or Partial Exclusions
Even if you don’t meet the standard requirements, special rules may still allow an exclusion:
- Divorce Settlements: If you receive ownership through divorce, you can count your former spouse’s ownership period.
- Temporary Absences: Short-term absences, even if you rent out the home, still count toward the use test.
- Divorce or Separation Agreements: If a spouse remains in the home due to a divorce agreement, the non-residing spouse may still qualify for the use test.
- Surviving Spouse: If a spouse dies and the surviving spouse has not remarried before selling, the ownership-and-use period of the deceased spouse counts toward the test.
Reduced Exclusion for Unforeseen Circumstances
If you sell your home before meeting the two-out-of-five-year rule due to employment changes, health issues, or other unforeseen circumstances (such as divorce or multiple births in one pregnancy), you may qualify for a partial exclusion.
- The reduced exclusion is based on the portion of the two-year period you met.
- Example: A married couple who lived in their home for only one year may qualify for a $250,000 exclusion instead of the full $500,000.
Military, Foreign Service, and Intelligence Agency Members
Members serving on “qualified official extended duty” can suspend the five-year ownership and use test for up to ten years if they are:
- Assigned to a duty station at least 50 miles from their home, or
- Residing in government housing under official orders.
Deciding Whether to Claim the Exclusion
In rare cases, it may make sense to decline the exclusion to preserve it for a future sale where the potential gain is higher. However, the exclusion can only be used once every two years.
Reporting the Home Sale on Your Tax Return
You generally don’t need to report your home sale unless:
- You receive a Form 1099-S (Proceeds from Real Estate Transactions) from the closing agent.
- You do not meet the exclusion criteria.
To avoid receiving Form 1099-S, you must assure the closing agent that:
- You meet the two-out-of-five-year rule.
- You haven’t sold another home using the exclusion in the past two years.
- No part of the home was used for business or rental purposes.
- The sale price is within the exclusion limits ($250,000 single/$500,000 married).
If you receive Form 1099-S, the IRS also receives a copy. If you qualify for the exclusion, you may not owe taxes, but keep records to support your claim.
Calculating Gain on a Home Sale
Your taxable gain is based on the difference between your selling price and your adjusted basis, which is:
- Original cost (purchase price and qualifying closing costs)
- Improvements (e.g., adding a new roof, remodeling, or installing central air conditioning)
- Subtractions for depreciation, casualty losses, energy credits, or gains postponed under prior tax laws
Basis Adjustments for Inherited or Divorced Property
- Inherited Homes: The basis is typically the fair market value at the time of the previous owner’s death (except in 2010, when special rules applied).
- Divorced Property Transfers: If received from a former spouse after July 18, 1984, the basis remains the same as when jointly owned.
Rollover Rules from Pre-1997 Home Sales
Before 1997, taxpayers could defer tax on home sale gains by purchasing a more expensive replacement home. If you used this rule, your basis in the replacement home was reduced by the amount of the deferred gain. This affects the taxable gain when selling the replacement home.
Converting a Second Home to a Primary Residence
Previously, homeowners could convert a second home to a primary residence, live there for two years, and exclude up to $500,000 in gains. However, after 2008, only the portion of ownership time used as a primary residence qualifies for the exclusion. Gains from periods when the home was a second home or rental are taxable.
Understanding these tax aspects of selling a home can help you maximize your exclusion benefits while staying compliant with IRS rules. Your partners at PSA CPA are happy to assist! Call us at 301-879-0600 or email us at [email protected] – we can’t wait to work with you!
0 Comments