This article was last updated on January 31
Following my recent post on Tips for Selling your Home, I received a reader email asking me to clarify the tax consequences of selling their home and what the potential liability/capital gain implications would be. Based on what the IRS says, here are the key tax facts to keep in mind around figuring your gains. taxes and exclusions on the sale of your home:
Amount of Taxes You Can Exclude. When you have gain from the sale of your home, you may be able to exclude up to $250,000 of the gain from your income (single filers). Taxpayers filing a joint return, the exclusion amount is $500,000. However, to claim the exclusion you need to meet the ownership and use test. The ownership test requires you to have owned the home for at least two years during the five year period ending on the date of the sale (the 2 years do not need to be consecutive). The use test requires you to prove that you have lived in the house and used it as your primary (main) residence for at least two years during the five year period ending on the date of the sale. This 2-out-of-5 year ownership and use test rule mean that you can only exclude your residential selling profits only once every two years (this is to prevent flippers from taking advantage of this tax provision).
Partial Exclusion. As with most tax deductions and credits, partial criteria also apply. If you lived in your home less than 24 months, you may still be able to exclude a portion of the gain. Exceptions are allowed if you sold your house because the location of your job changed, because of health concerns, or for some other unforeseen circumstance (e.g. natural disasters). But you will need to prove this if you are ever audited by the IRS. You calculate your partial exclusion based on the amount of time you actually lived in your home.
Reporting Requirements and Capital Gains. If you meet the ownership and use test and are able to exclude all of the gains up to $250,000/$500,000 from the sale of your home, you do not need to report the sale on your federal income tax return. However if you have gain which cannot be excluded, it is taxable and must be reported on your tax return using Schedule D as a capital gain. If you owned your home for one year or less, the gain is reported as a short-term capital gain. If your owned your home for more than one year, the gain is reported as a long-term capital gain.
Calculating Your Homes Adjusted Cost Basis: When figuring how much you have profited or lost from you home when selling you need to first work our the (adjusted) cost basis you can use in your taxes (this is different from the purchase price). Just like calculating capital gains on stocks, the adjusted cost basis for your house includes the purchase price, plus purchase costs (title, legal fees), improvements made during your stay (like a new bathroom), Selling costs (title & escrow fees, real estate agent commissions, etc.) and depreciation. Refer to the IRS guide for a listing of allowable costs.
When you include all these costs your cost basis will be at least 10 to 25% higher than the price you paid for your home – which benefits you when calculating your taxable gain or exclusion. So your final profit/gain on the house is calculated as Selling Price minus Cost Basis
Deducting a loss. You cannot deduct a loss from the sale of your home. However, under new rules if you short sale your home you may not have to pay taxes on the lower sale price or forgiven loan. Normally, mortgage debt owed to a financial institution that is cancelled or forgiven (e.g. in a short sale) is taxable. However, under the Mortgage Forgiveness Debt Relief Act of 2007, taxpayers generally can exclude income from the discharge of debt on their principal residence or mortgage restructuring. As an example suppose you borrow $300,000 to purchase a home and default on the loan after paying back $50,000. If the lender is unable to collect the remaining debt from you, there is a cancellation of debt of $250,000, which generally is taxable income to you. However, under the new forgiveness debt relief act, you will not have to pay tax on this amount
Rules for multiple homes. If you have more than one home, you may only exclude gain from the sale of your main home and must pay tax on the gain resulting from the sale of any other home. Your main home is generally the one you live in most of the time.
An Example of Figuring the Gains and Taxes on your Home
David and his wife, Amy, bought a house in July 2002 for $290,000. Closing costs and other fees were $7,000. While they lived in their home time they replaced the roof and finished their basement for a total cost of $15,000. During the 5 years they owned the house, David and Amy moved overseas on a work assignment for one year, and rented out their home in that period. They sold the home in August 2009 for $470,000. Based on the above, here is how you would calculate their gain and potential tax liability from selling their home:
Purchase Cost = $290,000
Closing Costs = $7,000
Home Improvements (basement, bathroom) = $15,000
Cost Basis for the House: $312,000
Sale Price : $470,000
Profit/Gain on the house : $158,000
Tax Implications : Despite having left the house for 1 year, David and Amy meet both the ownership and use test. Because they file as a married couple their allowable exclusion is $500,000, which means that they owe no taxes on the sale of their home. To have any tax liability there home sale price would have had to have been over $812,000!
For more information and details on all the rules around selling a house see IRS Publication 523, Selling Your Home.