Thinking of Selling Your Home? – Understanding the Home Gain Exclusion
Often a tax surprise occurs when selling your home. The possibility of capital gains tax should be understood before selling your residence. Here is a summary of the rules.
One of the largest tax breaks available to most individuals is the ability to exclude up to $250,000 ($500,000 married) in capital gains on the sale of your personal residence. Making the assumption that this gain exclusion will always keep you safe from tax can be a big mistake. Here is what you need to know.
The rule’s basics
As long as you own and live in your home for two of the five years before selling your home, you qualify for this capital gain tax exclusion. In tax-speak you need to pass three hurdles:
- Main home. This tax term defines what a main home is. It can be a traditional home, a condo, a houseboat, or mobile home. Main home also means the place of primary residence when you own two or more homes.
- Ownership test. You must own your home during two of the past five years.
- Residence test. You must live in the home for two of the past five years.
- Some quirks.
- You can pass the ownership test and the residence test at different times.
- You may only use the home gain exclusion once every two years.
- You and your spouse can be treated jointly OR separately depending on the circumstances.
When to pay attention
You have been in your home for a long time. The longer you live in your home the more likely you will have a large capital gain. Long-time homeowners should check to see if they have a capital gains tax problem prior to selling their home.
You have old home gain deferrals. Prior to the current rules, home-gains could be rolled into the next home purchased. These old deferred gains reduce the cost of your current home and can result in capital gain exposure.
Two homes into one. Often newly married couples with two homes have potential tax liability as both individuals may pass the required tests on their own property but not on their new spouse’s property. Prior to selling these individual homes, you may wish to create a plan of action that reduces your tax exposure.
Selling a home after divorce. Property transferred as a result of a divorce is not deemed a sale of your home. However, if the ex-spouse that retains the home later sells the home, it may have an impact on the amount of gain exemption available.
You are helping an older family member. Special rules apply to the elderly who move out of a home and move into assisted living and nursing homes. Prior to selling property it is best to review options and their related tax implications.
You do not meet the five-year rule. In some cases you may be eligible for a partial gain exclusion if you are required to move for work, disability, or unforeseen circumstances.
Other situations. There are a number of other exceptions to the home gain exclusion rules. This includes foreclosure, debt forgiveness, inheritance, and partial ownership.
A final thought
The key to obtaining the full benefit of this tax exclusion is in retaining good records. You must be able to prove both the sales price of your home and the associated costs you are using to determine any gain on your property. Keep all sales records, purchase records, improvement costs, and other documents that support your home’s capital gain calculation.
When does a tax benefit not become a tax benefit? When you assume you no longer need to keep track of something. This is the case with the home gain exclusion.
One of the more popular provisions in the tax code is the $250,000 capital gain exclusion ($500,000 for a married couple) of any profit made when selling your home. As long as you follow the rules, most home sales transactions are not a taxable event.
But what if the tax law is changed?
What if you rent out your home?
What if you cannot prove the cost of your home?
Your best defense to a potentially expensive tax surprise in your future is proper record retention.
The gain exclusion is so high, that many of us are no longer keeping track of the true cost of our home. This mistake can be costly. Remember, this gain exclusion still requires documentation to support the tax benefit.
To calculate your home sale gain take the sales price received for your home and subtract your basis. This “basis” is the original cost of your home including closing costs adjusted by the cost of any improvements you have made in your home. You might also have a reduction in home value due to prior damage or casualty losses. As long as the home sold is owned by you as your principal residence in at least two of the last five years, you can usually take advantage of the capital gain exclusion on your tax return.
To keep the tax surprise away
Always keep documents that support calculating the true cost of your home. This should include:
- Closing documents from the original home purchase
- All legal documents
- Canceled checks and invoices from any home improvements
- Closing documents supporting the value of the sale of the home
There are some cases when you should pay special attention to keeping track of your home value.
You have a home office. When a home office is involved, it can impact the calculation of the capital gain exclusion. This is especially true if you depreciated part of your home for business use.
You have lived in your home for a long time. Most homes will rise in value. The longer you stay in your home the more likely the value of your home will rise over time. For example, a sizable gain can occur when an elderly single parent sells their home after living in it for over 50 years.
You live in a major metropolitan area. Certain areas of the country are known to rapidly increase in value.
You rent out your home. Any time part of your home is depreciated, it can impact the calculation for available gain exclusion. Home rental also can impact the residency requirement calculation to receive the home gain tax exclusion.
You recently sold another home. The home sale gain exclusion can only be used once every two years. If you recently sold a home with a gain, keeping all documents related to your new home will be critical.
The best way to protect this tax code benefit is to keep all home-related documents that support calculating the cost of your property. Please call if you wish to discuss your situation.
ow that home values are on the rise once more, it makes sense to review the tax benefits of home ownership.
As always, should you know of someone who may benefit from this information please feel free to forward this newsletter to them.
Tax Benefits of Home Ownership
When it comes to tax savings it really is home sweet home. Here are some of the popular tax benefits of owning your own home and how to get the most out of your home’s tax advantaged status.
|Mortgage interest. Interest paid on your home mortgage is still tax deductible. This deduction is taken on Schedule A as an itemized deduction. Certain upward limits apply.|
|Property taxes. Property taxes paid on your home are also tax deductible as an itemized deduction.|
|Home Equity. Most homeowners can take out a second mortgage on the “equity” in their home. In most cases, this interest expense is also tax deductible. Many use home equity loans for purchasing autos, boats, and the like since interest on traditional loans is not tax deductible.
Idea: Consolidate credit card debt within a home equity loan or home equity line of credit if your home is worth more than your outstanding mortgage balance. You have the double advantage of deducting the interest on your tax return PLUS you avoid the higher interest rate on your credit card. A word of caution however, if you default on a payment your house is now the collateral.
|Capital Gains Exclusion. When you sell your home, up to $500,000 for joint filers ($250,000 for single taxpayers) of the increased value over what you paid for the home can be excluded from tax. To take advantage of this capital gains exclusion you must make the home your principal residence in two of the last five years.|
|Idea: The capital gain exclusion on home sale can be used more than once. For example, you could sell your qualified main home and take the exclusion. If you then made a second (vacation) home your new main home you could also take the gain exclusion once again. You would need to meet the IRS ownership and use rules to qualify. Special allocation rules might apply if this second home was also rental property.|
|Second home benefits. A second home (cabin or vacation home) can also benefit from interest and property tax deductibility as long as total mortgages do not exceed certain limits.|
Should you have any questions regarding your situation please feel free to call.
The temporary tax cut in Social Security expires at the end of the year. What will
your employer do? You had better check.
When you receive your initial paycheck for 2013 you had better take a close look to see what the payroll department has done with your pay. If you do not, you may be in for a big tax bite at the end of the year.
For years the Social Security tax was set at 12.4% of your earnings. 6.2% of the obligation was paid by your employer. The other 6.2% was paid by you, the employee. The tax was applied to a maximum of $110,100 of 2012 earned income for each employee. Despite the long-standing discussion regarding the impending insolvency of Social Security, Washington passed a 2% tax cut for 2011 and 2012 on the employee portion of this tax (from 6.2% to 4.2%). This provision expires beginning January 1, 2013 unless Congress acts to extend the 2% tax cut.
What you should do
- Check your pay. Make sure that your Social Security withholding is returned to 6.2%. If it has not been done, notify your payroll department immediately.
- Note the pay drop. Understand the impact of the return to historic Social Security tax rates on your income. Adjust your household spending to plan for this drop in your take-home pay.
- While you’re at it. While reviewing your initial 2013 pay stub for the Social Security adjustment, also review all your other withholdings. Many employers adjust other benefit costs at the beginning of each year. This includes retirement savings plans, employer retirement match programs, health insurance, dental insurance, and life/disability.
- Adjust your withholdings? Also check your state and federal withholdings to ensure they are accurate. If adjustments are required file a new W-4 with your employer.
- Self-employed too. The 2.0% re-set in Social Security rates also impacts self-employed individuals. Make sure you plan accordingly.
As a final note, please stay tuned. Our elected officials in Washington D.C. are full of surprises and may change Social Security tax rates once again.