Most people sell their houses for more money than they originally paid to purchase them. The difference between the price you pay to buy a home and the amount you receive when you sell it is generated by some combination of increases in value that have nothing to do with you and improvements that you put into the place. Fortunately, the IRS only defines the first factor as potentially taxable profit.
Suppose that you buy a house for $200,000 and sell it ten years later for $300,000. While you owned the place, you spent $20,000 remodeling the kitchen and bathroom. According to the IRS, your profit on the sale is $80,000. We'll get into more of the nitty-gritty details about all the items that the IRS requires you to consider in calculating your house sale profits.
Excluding house sale profits from tax
So, you've made a profit of $80,000 on the sale of your home. How much federal tax do you owe on it? Probably none. In fact, thanks to the Taxpayer Relief Act of 1997, single taxpayers can realize up to $250,000 and married couples up to $500,000 of profit on a house sale without having to pay any tax on it. Most people's house sale profits fit well under these limits.
As long as the house you're selling has been your principal residence for at least two of the previous five years, you can take the tax exclusion at any age and for as many times in your life as you want (but not more than once every two years). There are no restrictions on what you must do with the profits.
The old rules were much more restrictive: Before, if you were under age 55, you couldn't exclude any gain from tax; you could only "defer" it by purchasing a replacement residence which cost at least as much as the one you sold. If you were over age 55, you could take an exclusion, but it was only for $125,000 and just a once-in-a-lifetime deal.
In order for a married couple to qualify for the $500,000 exclusion, both spouses must individually meet the qualifications: that is, both spouses must have lived in the house for two of the previous five years and neither spouse can have taken an exclusion on another house sale during the previous two years. If only one spouse qualifies, then the couple is only allowed a $250,000 exclusion.
If you fail to meet the two-year requirements because of an unexpected move relating to your job, your health, etc., you are still entitled to a prorated amount of the exclusion based on how much time of the two-year requirement you were able to meet.
If you hold title to your house as a joint tenant with another person, you get a stepped-up basis for tax purposes on half of the property when the other joint tenant dies. If the title to the house is held as community property, both halves of the house get a stepped-up basis when one spouse dies. See the glossary and a good tax/legal advisor for more details.
After you sell your house, you don't need to immediately report the sale to the Internal Revenue Service. Rest assured, however, that the IRS knows of the sale because whatever firm handles the closing reports the financial details of the sale on Form1099-S. You should receive a copy of this form, as well.
Form 2119: "Sale of Your Home" When the time comes to file your annual IRS Form 1040, you need to complete Form 2119, "Sale of Your Home", if you sold your house. Whether you made or lost money on the sale, you must complete this form and file it with your Form 1040.
The first part of Form 2119 which you have to fill out no matter which rules you're subject to, is by far the hardest part to complete. You need to tally the expenses involved in selling your house, and you also need to determine the amount the IRS calls the cost basis of the house. Determining the cost basis gives many a house seller a headache because this figure reflects not only the amount you originally paid for the house but also the money spent on improvements while you owned the property.
To calculate your gain on the sale, you need to determine two important numbers: expenses of sale and adjusted cost basis of the house you sold.
After you sell your house, the IRS may allow you to deduct from the selling price certain expenses incurred in the transaction, such as the following:
Adjusted cost basis
For tax purposes, the cost basis of your house starts with the price you originally paid for it, including certain closing costs, which the IRS allows you to add to the purchase price of the house. During the time you own the house, however, that basis can change. Home improvements increase your cost basis by the dollar amount you spend on them.
In the eyes of the IRS, an improvement is anything that increases your home's value or prolongs its useful life, such as landscaping, installing a new roof, adding rooms, installing a new heating or air conditioning system, and so on. On the other hand, repairs that simply maintain your home's condition -- fixing a leaking pipe, repainting, replacing a broken window, spackling holes in walls and baseboards -- are not considered improvements.
Another factor that may affect your cost basis is depreciation taken for rental or business use of a portion of your property over the years. For example, if you convert your 2-car garage into an office or if you're renting a spare room, you can take depreciation on the portion of the property devoted to business or rental purposes. Depreciation reduces your property's cost basis. (Note: The portion of your property devoted to business or rental purposes is not eligible for the tax deferral under the primary residence tax deferral rules.)
Here's a simple example to show how the IRS wants you to calculate the gain on your house sale in Part I of Form 2119. Suppose that you bought your house for $100,000.Over the years of ownership, you spent the following on improvements:
$6,000 on a new roof
$2,500 on landscaping
$1,500 on new electrical wiring
Thus, you raise your cost basis in the property to $110,000. You sell the house for $200,000. However, after paying real estate commissions and other expenses of sale, you only receive $180,000. Thus, your profit as defined by the IRS comes to $180,000 - $110,000 = $70,000.
Exclusion and Taxable Gains
Once you've calculated your profit on the sale, figuring out how much, if any, of that gain is taxable is quite simple, thanks to the new capital gains rules for all houses selling after May 6, 1997. As long as the property has been used and owned as the sellers' principal residence for at least two of the five years before the sale, married couples are allowed to exclude up to $500,000 of profits from tax and single taxpayers up to $250,000.
If your profits are less than your allowable exclusion, you owe no tax on the sale. If your profits are greater than your allowable exclusion, then you pay capital gains tax on whatever amount exceeds the limit. The actual rate you pay on this amount depends on your tax bracket and how long you've owned the house. However, if you've owned the house longer than 18 months, you'll pay no higher than 20 percent, which is the maximum long-term capital gains rate.
As most of us are aware, the federal government isn't the only government entity that assesses and collects taxes on income (which includes capital gains) -- the vast majority of states do as well.
Most states simply use the reported gain on your federal form to assess whatever percentage the state levies. You will probably have to separately itemize and report the gain on a capital gains schedule for your state.
At the closing for your property's sale, you will be buried in an avalanche of paperwork. After you dig yourself out, you'll probably just want to run away from it all. Avoid this temptation: You've got to keep copies of all those papers for the good ol' IRS. Next time you file your taxes, you'll need documentation for the expenses and proceeds ofthe sale. And even after you file the necessary forms with your tax return, you'll want to hold onto this paperwork in case you're ever audited.
Keep proof of improvements and prior purchases
Whether they help you or hurt you, tax laws all have one thing in common: they're a headache. A perfect example is the law that allows you to add the cost of improvements to your home's cost basis during your years of ownership -- a potentially nice tax break, if you have a sizable capital gain. The problem is, in order to take advantage of this tax break, you need to save receipts for every dollar you spend on home improvements. And, for as long as you're a homeowner (which can be decades) and continue to defer paying tax on your profits, you have to hang onto these receipts.
We realize that saving all these receipts can seem like an exercise in futility. If you're never audited, your receipts may never see the light of day. In fact, if your house-sale profits fall under the exclusion limits, your adjusted cost basis for tax purposes is a moot point.
But the point of keeping documentation for tax purposes is to anticipate the unexpected; think of it as insurance. Someday, you may sell your house and owe tax on your profits. And, because you never know when one of those dreaded IRS audit letters will land in your mailbox, keep those receipts!
If you sell your house and don't immediately buy another one, you need to find a safe place to park your proceeds. You don't want to put that money somewhere volatile, such as the stock market, where a market crash on any given day, week, month, or year can delay the purchase of your new home for a long, long time. On the other hand, you also don't want tens of thousands of dollars languishing in a low- or no-interest checking or savings bank account.
Money market mutual funds offer you the best of both worlds -- safety and reasonable rates of return. Although money market funds are not insured by the Federal Deposit Insurance Corporation (FDIC), no money market fund has ever lost retail shareholder principal in the history of the fund business. In recent years, money market funds have yielded in the 5 to 6 percent range.
Like bank savings accounts, but unlike certificates of deposit, money market funds offer daily access to your money without penalty. Most money market funds also offer free check-writing privileges, usually with the stipulation that the checks are for at least $250 or $500.
If you're in a high tax bracket, consider a tax-free money market fund that may end up netting you a higher effective return than a taxable money market fund on whose dividends you must pay federal and state income taxes.
Double-check the tax rules for excluding tax on profits
A recently passed tax law allows you to exclude from tax a significant portion of the profits from the sale of your primary residence. Congress can't ever seem to leave things alone, though, so keep your eyes and ears open for possible changes to the real estate tax laws. If you base important decisions on outdated rules, you risk losing money.
Your Next Home
Selling your house and buying another takes a great deal of your time and money. The more often you move, the more these costs compound. So, when you choose your next home, choose carefully. Before you set your mind on living in one specific area or type of property, check out a variety of different areas and housing options that address your needs.
Think through your next down payment
After you sell your house, you may well have some choices about the size of the down payment on your next home purchase. At a minimum, we recommend that you make a down payment of at least 20 percent of the purchase price of your next home. Why? Because that's the percentage that generally qualifies you for the best mortgage programs available.
What if you can make more than a 20 percent down payment? In that case, the real question is whether you can earn a high enough return investing that extra money in mutual funds, stocks, bonds, and so on to beat the cost of borrowing money on your mortgage.
Younger home buyers willing to take on more investment risk should lean toward a 20 percent down payment, whereas older home buyers who tend to invest less aggressively should opt for larger down payments.
Remember that renting can be a fine strategy
Keep in mind that you have two years to defer tax on your house-sale profits. Don't feel pressured to rush into purchasing your next home, especially if you're having doubts about the location and the type of home you want.
Renting isn't "throwing money away," especially in the short-term. Buying a home you'll soon have to sell because it doesn't meet your needs or wants is throwing money away -- the transaction costs of buying and selling real estate can dwarf the short-term costs of renting.
If you're unsure about where you want to buy, try renting in the area you love most. If the neighborhood turns out to be everything you dreamed, then you're in the perfect position to move fast when homes in that area become available. On the other hand, if you find that the neighborhood is not as rosy as you thought, you can pat yourself on the back for not rushing into a purchase and use the rental as a base for investigating other options.
If you do rent, be sure to increase your income tax withholding or estimated quarterly payments. Your employer's benefit department can provide you with Form W-4 for using the "Estimated Tax Worksheet" that comes with Form 1040-ES.
Change Your Address
Although you may want those to whom you owe money to think that you've fallen off the face of the earth, you don't want to rack up late payment fees, interest charges, and damage to your credit report. And, more important to you, don't forget to include family and friends in your campaign to spread the word. And you don't want to lose track of any of your investment accounts, either. States throughout our great land have taken over billions of dollars in such lost accounts.
Don't delay informing all parties you know of your change of address! Visit or call your local post office and request a Mover's Guide, which includes a permanent Change of Address Order Card (or, on the Internet, go to the MoversNet site at http://www.usps.gov/moversnet). The Postal Service recommends that you complete and mail your Change of Address Order Card or Internet form 30 days before you move, to ensure timely forwarding of mail after the date of the move.
Information Deemed Reliable But Not Guaranteed
Copyright 2021 Donna Brun. All Rights Reserved.