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Thinking About Downsizing?

Dear Carrie,

I'm thinking about downsizing my home when I retire. Will I get hit with a tax bill when I sell my house? – A Reader

Dear Reader,

Pardon the pun, but this topic hits very close to home for me. As I prepare this column, my husband and I are packing up the past 14 years of our lives to move to a smaller home. Our youngest is off to college, and like so many others at this stage of life, we made the tough decision to leave our rambling (and high-maintenance) family abode.

Personal issues aside, there’s no question that downsizing can have many financial advantages. Having a smaller house can mean less upkeep and lower monthly expenses—to say nothing of potential cash from the sale. And as you mention, taxes can be a big part of the decision.

There has been a fair amount of confusion over this topic ever since the rules changed dramatically back in 1997. Many of us Baby Boomers remember the old days when you could trade up to a more expensive home within two years to postpone taxes, or take advantage of the once-in-a-lifetime exclusion for those who were 55 or older.

But it’s a new day. Under current law, if you sell your principal residence for a profit, up to $250,000 of that capital gain is excluded from tax.1 Married couples filing a joint return can exclude up to $500,000.

This means that many people won’t have to pay capital gains tax at all. Others, though, especially those who have owned their homes for decades and who live in areas that have experienced considerable appreciation, could face a significant bill.

First, the basics

In order to claim the maximum exclusion, you have to pass what the IRS calls the ownership and use tests. This means:

  1. You must have owned the house for two years.
  2. 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 the sale.

There are a few exceptions to these rules. For example, if you had to move before owning the home for two years because of a job change, or because you experienced what the IRS designates an “unforeseen circumstance,” such as a divorce or natural disaster, then the IRS will allow you to prorate the exclusion. (If you go through a divorce after having lived in the home for just one year, you would be entitled to 50% of the exclusion.)

And the two years of residency don’t have to be consecutive—you just have to have lived in your home for a total of 24 months out of the five years prior to the sale. Interestingly, you can claim this exclusion on multiple sales—as long as each home was your principal residence for at least two of the last five years.

Calculate your cost basis

To determine capital gains on the sale of your home, you simply subtract your cost basis from the selling price. But what exactly is your cost basis? It’s not just the purchase price. It also includes certain settlement fees, closing costs and commissions associated with both the purchase and the sale (excluding escrow amounts related to taxes and insurance, etc.).2 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 of these improvements will increase your cost basis, and therefore lower your potential tax liability. Hopefully, you’ve kept good records because this can add up!

On the other side of the equation, there are a few things that can reduce your cost basis. A lower basis will increase your profit, and potentially your tax. For example, if you have a home office and have claimed depreciation over time, you now have to subtract those deductions from your cost basis. Or if you received tax credits for energy-related improvements, you have to subtract that amount as well.

A sample tax bill

Jon and Jane bought their home in 1988 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 25% tax bracket and pay a 15% long-term capital gains tax rate. Here are the numbers:

Note: Jon and Jane must also include the $50,000 depreciation deduction on their tax return as “unrecaptured section 1250 gain.” It will be taxed at a rate of 25% ($12,500). They would have to do this even if their capital gain was less than their $500,000 exclusion.

Looking ahead: Rent or buy?

Your next big decision will be figuring out where to live. Downsizing may mean buying a smaller house or moving to a less expensive area. Alternatively, you could decide that it would make more sense to rent. 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. If you don’t sink your money into another house, it could also give you a nice retirement nest egg. On the minus side, if you rent 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 whether you plan to stay in your next home long term.

In either case, if you make a considerable profit on the sale of your home, talk to Schwab about the best way to invest this money in light of your overall financial situation.

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. The difference? A capital improvement increases the value of your property. A repair simply restores your property to its original condition.

A new deck is a capital improvement. Fixing your plumbing is a repair. Sometimes, though, the distinction is less clear. For example, if you replace your entire roof, that’s a capital improvement. But if you simply replace some of the shingles, that’s a repair.

1IRS Publication 523

2Ibid.

What you can do next

  • A financial plan can help you navigate major life events, like saving for the down payment on a home or a renovation.
  • Learn more about creating a customized plan and investment portfolio with Schwab Intelligent Advisory™ to work toward your goals.
  • Create your plan now or call 888-279-2756.
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