On the list of most stressful things a person can encounter in their personal life, selling a home is one of the top 5. Death, marriage, birth, purchasing a car, purchasing/selling a home are, in my opinion, the five stressors, and not necessarily in the order listed. I would say that purchasing/selling a home is one of the top 3 stressors.
First there comes the decision of selling the home. People sell their homes for many reasons, some good, and other reasons, not so good, such as the result of a divorce. Whatever the reason for selling your home, for the most part, the process is going to be the same.
So, what happens after the home is sold? What taxes, if any, do you have to pay? The answer to the question whether you will have to pay taxes on the sale depends on a few different factors such as whether the home is your primary residence, a 2nd home, or a rental home?
A home is classified as a capital asset by the IRS. When a capital asset is sold, the sale of that asset generates either a gain or a loss. If a gain is incurred, generally capital gains tax is required to be paid on the amount that exceeds the cost basis of the property. If the home is sold at a loss, no capital gains tax will be required to be paid, however, the sale of the home still needs to be reported on Schedule D and Form 8949 if it is your primary residence or your 2nd home.
If the home is a rental property, the sale is reported on the Form 4797 (Sales of Business Property) and Schedule D.
In brief, the cost basis of the property is the original purchase price, plus improvements. How do you determine if you have incurred a gain? You start with the cost basis. If the property sells for more than the cost basis, you incur a gain. If the property sells for less than the cost basis, you incur a loss. When selling a property that is, or was your primary residence, there is a big perk, if you meet the qualifications. That perk is the home sale exclusion. Some taxpayers refer to this perk as a loophole. Whatever you want to refer to it as, if you meet the qualifications, you can save a hefty sum in taxes and keep more of the proceeds from the sale in your pocket.
What is the home sale exclusion and how does it work?
In brief, IRC Section 121 allows a taxpayer to exclude up to $250,000 ($500,000 for certain taxpayers who file a joint return) of the gain from the sale of property owned and used as a principal residence for at least two of the five years prior to the date of the sale. The full exclusion can only be used once every two years. Partial exclusions are available to taxpayers who meet certain requirements, such as change of place of employment, health reasons, or certain unforeseen circumstances.
There are five eligibility requirements that need to be met before a taxpayer can qualify for the full home sale exclusion, which you can inquire about with your CPA.
Eligibility Test determines whether you are eligible for the maximum exclusion of gain ($250,000 or $500,000 if married filing jointly).
- Eligibility Step 1 – Automatic Disqualification – Your home sale isn’t eligible for the exclusion if you either acquired the property through a like-kind exchange (1031 exchange) during the past 5 years OR if you are subject to expatriate tax.
- Eligibility Step 2 – Ownership – If you owned the home for at least 24 months (2 years) out of the last 5 years leading up to the date of the sale, you meet the ownership requirement. For a married couple filing jointly, only one spouse must meet the ownership requirement.
- Eligibility Step 3 – Residence – If you owned the home and used it as your residence for at least 24 months of the previous 5 years, you meet the residence requirement. This does not need to be in a single block of time – simply 24 months (730 days) of residence during the 5-year period. Unlike the ownership requirement, each spouse must meet the residence requirement individually for a married couple filing jointly to get the full exclusion. If you were ever away from home, you need to determine whether that time counts towards your residence requirement.
- Eligibility Step 4 – Look-Back – Determine whether you meet the look-back requirement. If you didn’t sell another home during the 2-year period before the date of sale, (or if you did but didn’t claim the exclusion), you meet the look-back requirement. You may take the exclusion only once during a 2-year period.
- Eligibility Step 5 – Exceptions to the Eligibility Test – Some exceptions would be if you are either acquiring or relinquishing the home in a like-kind exchange. This would apply to separated or divorced taxpayers and widowed taxpayers (see Like-Kind/1031 Exchange). Also, you may be able to increase your exclusion amount from $250,000 to $500,00.
Please be aware that there are there are different elements of eligibility if you are a member of the Armed Forces.
For tax purposes, you will receive a Form 1099-S from the person or company responsible for closing the sale. This form is required to be sent to the IRS and given to the seller. You will need information from Form 1099-S when completing your tax return, so keep this form in a safe place.
If you are thinking about selling your home and have any questions relating to the tax consequences, please contact my office.