It's smart to understand your potential capital gains tax liability before you put your house on the market.
An individual can exclude up $250,000 of profit on a home sale from their taxable income; a married couple can exclude up to $500,000.
To qualify for these exclusions, the seller must pass the IRS ownership and use tests.
Two and a half years ago my husband and I moved from a home we had owned and lived in for ten years. At that time we bought a new house and have been renting out the old one. Will we have to pay capital gains if we sell the old house?
Great question—and good you're asking it now. That's because, while there are generous exclusions allowed when it comes to capital gains on the sale of a home, timing is crucial and the clock is ticking.
Under current laws, if you sell your principal home and make a profit, you can exclude $250,000 of that profit from your taxable income. And that's just the exclusion for an individual. Married couples can exclude up to $500,000 (if both spouses each meet the ownership and use tests below). So, depending on how much of a profit you make on the sale, you and your husband could potentially have no capital gains tax bill at all.
I say 'potentially' because in order to claim the maximum exclusion, you have to pass what the IRS calls the ownership and use tests. This means:
- You have to have owned the house for two years.
- You have to 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 as an "unforeseen circumstance," such as a divorce or natural disaster. In these situations the IRS will allow you to prorate the exclusion.
And interestingly, the two years residency doesn'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.
It sounds like you easily pass the ownership test. However, since you've been out of your prior home for two and a half years, you have only six months left to meet the residency requirement. So there's no time to lose. Here's what I suggest to help you determine your potential taxes and maximize your exclusion.
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.—see IRS Publication 523 for more information). 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.
Estimate sale price and capital gains
Now estimate your sale price and subtract your cost basis. Let's say you bought your house for $350,000, put in $50,000 in improvements and had related fees and costs of another $15,000, giving you a cost basis of $415,000. Now let's say you expect to sell the house for $850,000. Your potential capital gain would be $435,000.
Factor in exclusion
In the above example, if you met both the ownership and use tests, you and your husband could exclude the entire gain from your taxable income. You wouldn't even have to report the sale on your tax return. However, let's say your capital gain turned out to be $525,000. In that case, you'd have to report the sale and pay long-term capital gains on $25,000.
In your situation, with only six months left to meet the residency requirement, I'd get your home on the market as soon as possible. The five-year residency period is from the date of purchase to the date of sale. On the bright side, if you successfully sell your old home within the time limit and take the exclusion, you can take it again should you decide to sell your current home—as long as the two sales are more than two years apart. Good luck with your sale.
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