White house with red roof, has two trees behind, sits on cross section of earth cut to show layers, and has SOLD tag attached to house.
Selling Homes

Summer is the peak season for selling homes in many parts of the country. If you are planning on putting your home on the market soon, you are probably thinking about things like how fast it will sell and how much you’ll get for it. However, don’t forget to consider the tax consequences.

Article Highlights:

  • Home Sale Exclusion
  • 2 out of 5 Rule
  • Business Use of the Home
  • Gain or Loss from a Sale
  • Previous Use as a Rental
  • Form 1099-S IRS Matching
  • Records

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 home ownership, including by providing a tax break for taxpayers selling their homes. The current version of the tax code, allows 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.

Selling Homes and the 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. For persons who 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. However, when only one spouse in a married couple is qualified, then the maximum exclusion gets 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.

Sometimes 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: Being 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 contact us if you don’t meet the 2 out of 5 rule. We can look 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. When you owned the home for at least a year and a day, the gain is a long-term capital gain; which triggers the special capital-gains rate, which ranges from zero for low-income taxpayers to 20% for high-income taxpayers. When your income is high, the gain can also be taxed by an additional 3.8% net investment income surtax. The tax computation can be rather complicated, so please call this office for assistance.

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 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.

Selling Homes Can Generate a Form 1099-S

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. Some 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, leaving income off the tax return (unreported income) often leads to IRS questions. Like correspondence (i.e., a bill for tax due) from the IRS when it attempts to match the sales price shown on the 1099-S to the seller’s tax return. To avoid problems with the IRS, you should report the home’s sale on your income tax return. By doing so, you will be including your basis and exclusion information for the IRS.

Record Keeping

Assets worth hundreds of thousands of dollars, including your home, need your attention, particularly regarding records. When calculating a gain or loss, you need at least two closing statements: One from the purchase, the other from sale. Optional, but helpful is a list of improvements (not maintenance work) with receipts. If you encounter any of the issues discussed in this article, you may need additional documentation.

There are some more home-sale rules we did not include here. Selling homes has some complicated computations and tax reporting. Please contact us for assistance.

Personal Taxes

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Categories: Personal Taxes