Downsizing your home, whether by moving into a smaller home or to a more affordable neighborhood, can help lower your monthly expenses and maintenance costs, and maybe even generate extra cash from a sale.
But it's important to factor the potential taxes into any decision. Selling your home may not be worth it if it triggers a big tax bill.
The basics
Under current law, if you sell your principal residence for a profit, you may be able to exclude up to $250,000 (or $500,000 for married couples filing jointly) of capital gains from your income tax. (See IRS Publication 523 for more details.) This may not be an issue for most people, but if your home has appreciated considerably, you could face a significant bill.
To claim the maximum exclusion, you'll need to pass what the IRS calls the ownership and use tests. This means:
- You must have owned the house for at least two years.
- And you must have lived in the house as your principal residence for two out of the last five years, ending on the date of sale.
There are exceptions to these rules—for example, moving before owning the home for two years due to a job change or experiencing what the IRS designates an "unforeseen circumstance," such as a divorce or natural disaster. In such cases, the IRS will allow you to prorate the exclusion. One thing to note: If you divorce after having lived in the home for just one year, you would be entitled to only 50% of the exclusion.
Additionally, the two years of residency don't have to be consecutive, as long as you've lived in your home for a total of 24 months out of the five years prior to the sale.
If you meet all of the requirements for the exclusion, you can claim it any number of times over your life. But be aware that you can only claim it once every two years. Typically, however, people live in a home for more than two years before they sell it.
Calculate your cost basis
To determine any capital gains, you must subtract your "cost basis" from the selling price.
Your cost basis is not just the purchase price. It can include certain settlement fees, closing costs, and commissions associated with both the purchase and the sale—excluding escrow amounts related to taxes and insurance, etc. Add to this the cost of significant capital improvements (but not repairs) you made over time for renovations, additions, roofing, landscaping, and other upgrades. All these improvements will increase your cost basis and, therefore, lower your potential tax liability. Hopefully, you've kept good records because these can add up.
On the other side of the equation, there are a few things that can reduce your cost basis, which would increase not just your profit but potentially your taxes as well. For example, if you received tax credits for energy-related improvements, you'll have to subtract those amounts from your cost basis. Also, if you ever claimed depreciation for a home office, you may have to "recapture" and pay tax on that amount.
Capital improvement or repair?
Tax rules let you add the cost of a capital improvement to your cost basis but not the cost of a repair. But how do you tell the difference between the two? A capital improvement increases the value of your property. A repair simply restores your property to its original condition.
Adding a new deck is a capital improvement. Fixing your plumbing is generally a repair. Sometimes, though, the distinction is less clear. If you decide to replace an old asphalt shingle roof with a high-end metal roof, that's a capital improvement. But if you replace a section of your roof to fix a leak, that's likely a repair.
A sample tax bill
Jon and Jane bought their home in 1990 for $250,000. Now in their mid-60s, they've decided to downsize. They sell their home for $875,000.
Over the years, Jon and Jane did a lot of remodeling and made many home improvements. Because Jane has a home office, they've claimed depreciation on their income tax return, which now has to be subtracted from the cost basis. They are in the 15% long-term capital gains tax bracket.
When Jon and Jane bought their home, they paid $12,500 in allowable settlement fees and closing costs at the time of purchase, and over the years, they spent $50,000 remodeling their kitchen and master bath, $20,000 on a new roof, and $15,000 on new landscaping, for a total cost basis of $347,500—since all of those expenses are added to the value of their home. Because they had to recapture $50,000 of depreciation costs for Jane's office, the total cost basis of their home is reduced to $297,500.
| Purchase price of home | $250,000 |
|---|---|
| Allowable settlement fees and closing costs: | +$12,500 |
Kitchen bath and remodels: | +$50,000 |
| New roof: | +$20,000 |
| New landscaping: | +$15,000 |
TOTAL | =$347,500 |
| Less: Depreciation from home office | -($50,000) |
COST BASIS | $297,500 |
What did they sell it for?
Jon and Jane sell their house for $875,000, but the $55,000 in commission and sales fees reduces their gross profit to $820,000.
| Sales price | $875,000 |
|---|---|
| Commission and sales fee: | -($55,000) |
| GROSS PROFIT | =$820,000 |
How much did they make?
After subtracting their cost basis of $297,500 from their gross profit of $820,000, Jon and Jane will earn $522,500 in capital gains.
| Gross Profit | $820,000 |
|---|---|
| Cost basis | -($297,500) |
| CAPITAL GAINS | =$522,500 |
How much do they owe in capital gain taxes?
Because Jon and Jane are filing jointly, they can exclude up to $500,000 of their capital gains, leaving them with a taxable capital gain of $22,500. Based on their income, their long-term capital gains tax rate is 15%, resulting in a capital gains tax bill of $3,375.
| Capital gains | $522,500 |
|---|---|
| Capital gains exclusion (married filing jointly): | -($500,000) |
| Taxable gain | =$22,500 |
| Long-term capital gains tax rate (15%) | x 0.15 |
| CAPITAL GAINS TAX DUE | =$3,375 |
What about renting?
What if you want to sell your home but aren't interested in being a homeowner anymore? On the plus side, renting releases you from worry about things like property taxes and upkeep—potentially giving you more freedom, both economically and emotionally. And if you don't commit a chunk of money to another house, you could use the proceeds from a home sale to help fund your retirement. On the minus side, renting means you won't be building equity and you'll be subject to the whims of a landlord.
There's no right or wrong answer. A lot will depend on where you live and how long you plan to stay in your next home. In either case, if you make a considerable profit on the sale of your home, talk to your financial advisor about the best way to invest this money in light of your overall financial situation.
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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
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The information and content provided herein is general in nature and is for informational purposes only. It is not intended, and should not be construed, as a specific recommendation, individualized tax, legal, or investment advice. Tax laws are subject to change, either prospectively or retroactively. Where specific advice is necessary or appropriate, individuals should contact their own professional tax and investment advisors or other professionals (CPA, Financial Planner, Investment Manager) to help answer questions about specific situations or needs prior to taking any action based upon this information.
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