Home prices are on fire in South Florida and elsewhere. No wonder several of our clients are taking advantage of sky-high real estate valuations to sell. But once you sell, could some of that money be owed to the IRS for taxes? That’s one of the most common questions our clients are asking.
Here’s a question we just received from one of our blog readers (names and details have been changed to protect our reader’s privacy):
My wife and I (in our late 70’s) just sold our free and clear home in Scottsdale, AZ, which we had lived in for 30+ years, for $556,000.
Our total income from Social Security, IRA withdrawals and small investments is around $50,000.00. My wife & I file joint tax returns.
Our net from the sale of the house after sales costs and real estate commissions is roughly $521,000. We paid $81,000.00+ for the house and have made improvements over the years. Can you help me understand how taxes affect us?
Making money on the sale of your home is usually not taxable
Let’s review the rules quickly, to see what taxes Michael and his wife might owe:
First of all, forget the old rules about avoiding tax if you buy a new home that’s more expensive. Or the rules about sellers 55+ or older who could exclude $125,000 of profits. Those rules went out the window years ago, although for some reason they seem to stick in clients’ minds.
The new rules are actually simpler. Basically, you can ignore the first $250,000 of profits on the sale of your home if you’re single, and the first $500,000 if you are married.
But if you make over $250,000 (single) or $500,000 (married) in profits, you’ll likely owe capital gains tax on the excess.
This ability to eliminate up to 500k of gains is a huge tax boon Congress has provided to homeowners to encourage homeownership.
Of course, to take advantage of these provisions, there is the usual IRS fine print. To take advantage of these exclusions, you need to have lived in the home as your principal residence for at least two of the last five years before the sale. Special rules apply if you recently divorced, were widowed, were posted overseas in the military or other government service, and so forth. To ensure you cross your “t’s” and dot your “i’s,” make sure to read the full IRS guidelines.
It’s all in how you measure it
But here’s the really important part. Even if you think you made over 250k or 500k in profit, like Michael and his wife, don’t despair. You may not need to pay tax. Here’s why:
There are significant adjustments that increase your cost basis (what the IRS says you paid for the house) or decrease your selling proceeds. Those adjustments potentially reduce your profits and may eliminate any taxes.
What kind of adjustments are we talking about?
- Construction costs including architect and legal fees, building permits and materials and labor.
- Improvements you may have made to the house, such as adding a pool, an addition, a new roof or windows.
- Purchase costs like settlement fees or closing costs.
- Repairs made to prepare the house for sale—like painting, wallpapering, planting flowers, maintenance and the like—provided you complete them within 90 days of the sale and provided they were completed to make the home more saleable.
- Selling expenses including commissions, advertising and legal fees, and seller-paid loan charges.
- A step-up in basis at the death of an owner (for example, increase in cost basis when the husband dies, leaving the widow as the sole owner of the property).
Once you add in these adjustments, you might just find your big gain turns out to be not so big (and much less taxable!).
Will Michael and his wife owe tax?
Let’s go back to Michael’s question. Michael and his wife look like they meet the eligibility requirements to exclude gains on their home sale. After all, they’ve lived in the house as their principal residence for 30+ years.
Their net proceeds from the sale (after sales commissions and so forth) are about $521,000. They originally paid $81,000 for the house. They actually put more money into the house through improvements, which they could potentially factor in as well. But even without factoring in those improvements, their gains on the house sale have shrunk to under $500,000 ($521,000 minus the cost basis of $81,000 equals $440,000).
So while they may need to report the home sale on their tax return, no taxes are likely due since their gains fall under the $500,000 allowance provided by Congress.
Financial planning tips if you plan to sell your home
Good records can save you thousands of dollars in tax. Take 5 minutes right now to identify a safe place to keep important home records affecting your cost basis (like receipts documenting work done), or track the data on a computer program like Quicken. If you’ve been in the home for many years, it’s hard to go back “after the fact” to reconstruct these important calculations from memory, so make sure to save receipts as you go. Good records can save you thousands of dollars in potential tax.
Reporting the sale. If you sold your home, look for Form 1099-S “Proceeds from Real Estate Transactions” in your mailbox. Make sure you give a copy of that form, along with other important closing documents, to your tax preparer so they can calculate potential gains and report the sale.
How capital gains work. If your gains exceed the $250,000 or $500,000 allowance and you do owe tax, there’s a silver lining. Assuming you owned your home for over a year, you will be taxed at long-term capital gains rates of 0%, 15% or 20%. While they may sting, those rates are lower than what you would owe on salary or other income. Sorry, losses on your home are not deductible.
Get professional help. Ask your tax preparer or financial advisor for guidance if you need help calculating your cost basis after a sale. There are many exceptions that you may be eligible for, including partial gain exclusion, so always consult a professional.