Pay as You Leave

Richard Connor

MY BROTHER and sister-in-law are approaching retirement age and will likely relocate so they can be nearer their children. The last time they sold a house, it took more than a year to find a buyer. But they’ve spent time and money fixing up their current home, and it’d likely sell quickly, especially in today’s hot real estate market. Their thought: Why not sell now, and then rent for a few years until they retire and move?

That possibility raised a key question: Would the sale of their home be taxable? It’s an issue that confuses many.

The Taxpayer Relief Act of 1997 created a permanent capital-gains exclusion for those selling their main home. Today, the tax code provides a $250,000 exclusion on the sale of a primary residence for tax filers who are single and a $500,000 exclusion for those married filing jointly.

IRS Publication 523 provides detailed explanations and instructions—and it does a good job of making the topic understandable. Want to know more? Here’s a look at four key questions:

1. Are you eligible? To qualify for the exclusion, you must pass an ownership test, a residency (or use) test and a look back test. The quick answer: To be eligible, you must have owned and used your home as your main residence for a period totaling at least two years out of the five years prior to the date of sale. In addition, there’s a look back test, meaning you can’t have used the exclusion in the last two years.

There are some exceptions to the eligibility test for divorce, death and military or government service. Under certain circumstances, you may be eligible for a partial exclusion. These circumstances include a work-related move, a health-related move or unforeseeable circumstances.

2. Do you have a gain? To determine if you have a gain when selling your home, it helps to have good records. You need to know the selling price, selling expenses and the adjusted cost basis. The IRS uses these two formulas to calculate a gain or loss:

  • Selling Price − Selling Expenses = Amount Realized
  • Amount Realized − Adjusted Basis = Gain or Loss

Selling expenses are the costs directly associated with selling your home, including commissions and fees. Meanwhile, the adjusted basis is the total cost basis of your home. Publication 523 has an extensive section to help you figure out your adjusted basis. It includes the amount you paid for the home, closing costs associated with the purchase and the cost of home improvements. Improvements are things that add value to your home. General repairs don’t add value and hence aren’t added to the cost basis. On the other hand, if the repairs were done as part of a larger remodeling project, they may be included.

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3. Is your gain taxable? If you’ve passed the eligibility test and determined you have a gain, you need to figure out what portion of the gain is taxable, if any. In addition to the ownership, use and look back tests, there are a few more things you need to verify.

  • You didn’t acquire the property through a 1031 like-kind exchange within the past five years.
  • You aren’t subject to the expatriate tax.
  • The sale doesn’t involve the transfer of vacant land or a remainder interest.

If none of the above is true, you’re eligible for the exemption. Again, this is $250,000 for single filers and $500,000 for those married filing jointly. If you have a gain larger than the applicable exclusion, the amount above the exclusion is taxable. There are worksheets in Publication 523 that take into account special circumstances and help you calculate the taxable amount of your gain.

4. Do you have to report the gain or loss on your home sale? You need to include the gain on your tax return if any one of the following three conditions applies:

  • You have a gain on your home sale that’s larger than the exclusion.
  • You received a Form 1099-S. If so, you must report the sale on Form 8949 even if you have no taxable gain to report.
  • You wish to report your gain as taxable even though some or all of it is eligible for the exclusion. Why would you do that? Let’s say you plan to sell another home within the next two years and are likely to receive more benefit from the use of the exclusion with this later sale. Of course, you might do that—opt to report a taxable gain on the earlier sale—only to realize it was the wrong choice. In that case, you can undo the choice by filing an amended return, but you must do so within three years of the due date for the tax return that reported the earlier sale.

Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. He enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. Follow Rick on Twitter @RConnor609 and check out his earlier articles.

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William Perry
William Perry
1 year ago

I would note that in most seller closing statements there is typically language that the settlement statement is a substitute 1099-S. The take away is almost every sale needs to be reported in your personal return to avoid a needless mismatch issue with the taxing authorities.
Also, if part of the home has been treated as a deductible office-in-home business deduction or for rental purposes in the past then the gain exclusion typically cannot be claimed to the extent of prior depreciation adjustments.

Gene Simmons
Gene Simmons
1 year ago
Reply to  William Perry

Note that the depreciation adjustments do not apply if you use the simplified version of the home office deduction.

1 year ago

One interesting point is that the gain on a house greater than the exclusion amount is just a capital gain, and goes into the pot with all your other capital gains. So if you have a large loss carryforward, or you can do loss harvesting in your stock portfolio, you can offset the gain on your house.
Of course, you should be sure to increase your basis by the cost of all the improvements you have made while you owned the house. This will lower your taxable gain, if any. There is a worksheet in Pub 523 for this purpose, but on your actual 8949 you only put the final number.

1 year ago

If you sold a home prior to the 1997 law mentioned here and purchased a replacement home of equal or greater value, you were able to postpone the recognition of the gain from that sale until selling the replacement home. Such a postponement would reduce your basis in the replacement home and increase your gain and potentially tax on the sale.

Rick Connor
Rick Connor
1 year ago
Reply to  stelea99

Great point. The people I was helping were post-1997, but there are many pre-1997 home owners out there. Our old neighbor just sold her home that she purchased in 1964!

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