In spite of (or in some cases, because of) the COVID-19 pandemic, and with near-record-low home mortgage interest rates, the housing market has been booming. September 2020 existing home sales were up 9.4% from August 2020 and 20.9% from 2019, according to the National Association of Realtors. If you sold your home this year or are thinking about selling it, there are many tax-related issues that could apply to that sale. To help you prepare for reporting the sale you may have already made or make you aware of what issues you may face if you are in the “thinking about” stage, this article covers the tax basics and some special situations related to home sales and the home-sale gain exclusion.
Home Sale Exclusion
For decades, Congress has encouraged homeownership, including by providing a tax break for taxpayers selling their homes. Under the current version of the tax code, you are allowed an exclusion of up to $250,000 ($500,000 for married couples) of gain from the sale of your primary residence if you owned and lived in it for at least 2 of the 5 years previous to the sale. You also cannot have previously taken a home-sale exclusion within the 2 years immediately preceding the sale. There is no limit on the number of times you can use the exclusion as long as you meet these time requirements; however, extenuating circumstances can reduce the amount of the exclusion. The home-sale gain exclusion only applies to your main home, not to a second home or a rental property.
2 out of 5 Rule
As noted above, you must have used and owned the home for 2 out of the 5 years immediately preceding the sale. The years don’t have to be consecutive or the closest to the sale date. Vacations, short absences, and short rental periods do not reduce the use period. If you are married, to qualify for the $500,000 exclusion, both you and your spouse must have used the home for 2 out of the 5 years prior to the sale, but only one of you needs to meet the ownership requirement. When only one spouse in a married couple qualifies, the maximum exclusion is limited to $250,000 instead of $500,000.
Although this situation is quite rare, if you acquired the home as part of a tax-deferred exchange (sometimes referred to as a 1031 exchange), then you must have owned the home for a minimum of 5 years before the home-gain exclusion can apply.
If you don’t meet the ownership and use requirements, there are some situations in which a prorated exclusion amount may be possible. An example of this situation would be if you were required to sell the home because of extenuating circumstances, such as a job-related move, a health crisis, or other unforeseen events. Another rule extends the 5-year period to account for the deployment of military members and certain other government employees. Please call this office if you have not met the 2 out of 5 rule to see if you qualify for a reduced exclusion.
Business Use of the Home
If you used your home for business and claimed a tax deduction—for instance, for a home office, storing inventory in the home or using it as a day care center—that deduction probably included an amount to account for the home’s depreciation. In that case, up to the extent of the gain, the claimed depreciation cannot be excluded.
Figuring Gain or Loss from a Sale
The first step is to determine how much the home cost, combining the purchase price and the cost of improvements. From this total cost, subtract any claimed casualty loss deductions and any depreciation taken on the home. The result is your tax basis. Next, subtract the sale expenses and this tax basis from the sale price. The result is your net gain or loss on the sale of the home.
If the result is negative, the sale is a loss; losses on personal-use property such as homes cannot be claimed for tax purposes. If the result is a gain, however, subtract any home-gain exclusion (discussed above) up to the extent of the gain. This is your taxable gain, which is, unfortunately, subject to income tax. If you owned the home for at least a year and a day, the gain will be a long-term capital gain; as such, it will be taxed at the special capital-gains rate, which ranges from zero for low-income taxpayers to 20% for high-income taxpayers. Depending on the amount of all of your income, the gain may also be subject to the 3.8% net investment income surtax that was added as part of the Affordable Care Act. The tax computation can be rather complicated, so please call this office for assistance.
Another issue that can affect your home’s tax basis (discussed above) applies if you purchased your home before May 7, 1997, after selling another home. Prior to that date, instead of a home-gain exclusion, any gain from a sale was deferred to the replacement home. Although this is now rare, if it matches your situation, the deferred gain would reduce your current home’s tax basis and add to any gain for the current sale.
Prior Use as a Rental
If you previously used your home as a rental property, the law includes a provision that prevents you from excluding any gain attributable to the home’s appreciation while it was a rental. The law’s effective date was the beginning of 2009, which means that you only need to account for rental appreciation starting in that year. This law was passed to prevent landlords from moving into their rentals for 2 years so that they could exclude the gains from those properties. Prior to the law change, some landlords had done this repeatedly.
Usually, the settlement agent—typically an escrow or title company—prepares IRS Form 1099-S, Proceeds from Real Estate Transactions, which reports the home seller’s name, tax ID number, proceeds of the sale, date of the sale, etc. This form is provided to both the IRS and the seller. Note that this form only includes information from the sale; it doesn’t provide any basis information to the IRS. Sometimes, sellers think that if the home sale gain exclusion eliminates all of their gain from the sale of their home, they don’t need to report the transaction on their tax return. Unfortunately, this thinking could lead to correspondence (i.e., a bill for tax due) from the IRS as it attempts to match the sales price shown on the 1099-S to the seller’s tax return. To avoid this interaction with the IRS, you should report the home’s sale on your income tax return for the year of the sale; in doing so, you will be including your basis and exclusion information for the IRS.
Assets worth hundreds of thousands of dollars, including your home, need your attention, particularly regarding records. When figuring your gain or loss, you will, at a minimum, need the escrow statement from the purchase, a list of improvements (not maintenance work) with receipts, and the final escrow (settlement) statement from the sale. If you encounter any of the issues discussed in this article, you may need additional documentation.
A few other rare home-sale rules are not included here. As you can see, home-sale computations and tax reporting can be very complicated, so please call this office if you need assistance.