The pandemic ignited change in many ways, including a boom in home sales. Individuals suddenly needed additional space to work and live and also had an interest in relocating as remote work became a reality for many professionals. Because of this, individuals and families across the country decided to sell their homes in 2020 or 2021 — and many of these homes sold at all-time high prices. If you’re thinking of taking this step, here are some important tax considerations before putting your home on the market.
Under the current federal tax law, Internal Revenue Code Section 121 allows for the exclusion of gain on the sale of a principal residence of up to $500,000 for married couples and $250,000 for single individuals if the home sold was your principal residence for two of the last five years.
You also must not have taken advantage of the gain exclusion on the sale of a personal residence in the two years before the sale of your current personal residence. If the gain on the sale of your personal residence is lower than the gain exclusion amounts, only the amount of the gain on the sale of the principal residence is exempt from taxation.
You may be able to exclude some of the gain on the sale of your personal residence if you owned the personal residence for fewer than two years if your reason for moving is related to a job change, health issues or other qualifying reasons. You should consult with your tax advisor if you are selling your personal residence prior to the two-year holding period and you have a qualifying reason for selling the home.
Real estate is generally an appreciating asset, but there are times when a home is sold at a loss — even in the current real estate environment. Unfortunately, the loss on the sale of a personal residence, or any personal asset for that matter, is considered a non-deductible loss. The loss cannot be used to offset other gains from other investments.
To determine your gain from the sale of your personal residence, there are four main components to this computation: sales price, less your closing costs, original purchase price, and improvements made during your holding period.
The sales price is the gross price you receive for the sale of your home before reductions for closing expenses, payoff of debt, and holdback of property taxes (if applicable).
Closing costs can include real estate commissions paid, title insurance, and other title and recording fees.
Your original purchase price is the original amount you paid for the residence plus any qualifying closing costs paid by you, the buyer.
Improvements made to your home are expenditures that add market value, prolong the useful life of the home, or adapt the home to a new use. Small repairs and yard maintenance would not be considered improvements for determining your net gain on the sale of your personal residence.
Depending on the U.S. state where your personal residence is sold and where you are currently a resident, the state may require a nonresident income tax withholding to be taken out at closing based on the gross sales price. At times, a state will allow for a sale to be exempt from this withholding if the sale of the residence is at a known loss, but other states do not have such an exemption from withholding.
For example, Colorado requires a 2% state income tax withholding based on the gross sales price of the sale of a home by a non-Colorado resident regardless of if there is a net gain or loss that would be subject to the state tax. If a refund of this tax is determined, the refund would need to be requested on a state income tax return filing which reports the net gain or loss on the sale of the home.
While there are some generous gain exclusions included in the federal and some state tax codes, there are some situations where some or all of the gain from the sale of a residence is subject to tax.
First, if you do not qualify for the gain exclusion on the sale of your personal residence, all of the gain will be subject to tax. The holding period of the home will determine if the gain is long-term or short-term. To qualify for the beneficial long-term holding period tax rate, you must own your home for at least one year and one day. If the gain from the sale of your home is in excess of the allowable exclusion amount ($500K for married couples and $250K for single individuals), the excess gain will be subject to income tax. Due to higher-than-normal prices in the real estate market, there is a good likelihood that more taxpayers will have gain on the sale of their personal residence exceeding the gain exclusion allowed.
In addition to paying income tax on the sale of your personal residence, the gain may also be subject to the 3.8% Medicare surtax on investment income. The Medicare surtax only applies to certain taxpayers with modified adjusted gross income over $250,000 for married couples or $200,000 for single individuals. To the extent the gain on your personal residence is exempt from tax, that portion of the gain is not subject to the Medicare surtax.
States each have their own approach to the taxation of the gain from the sale of a personal residence. Some states follow the federal gain exclusion amounts discussed earlier in this article; some states have a separate gain exclusion amount as well as different rules to qualify for the gain exclusion; and some states do not have a gain exclusion at all and tax the full gain regardless of how long you owned the personal residence. You should consult with your tax advisor before selling your home if your home is located in a state that assesses a state income tax.
In addition to understanding what gain is excluded from income tax, there are also additional considerations to know as you sell your personal residence. To the extent that you depreciated your home while you lived there as an office for a small business or as a partial rental, there may be a portion of the gain that is recaptured at a rate higher than the long-term capital gain tax rates.
This recapture would be assessed regardless of if the full gain on the sale of your residence falls under the $500K/$250K gain exclusion amount for federal income tax purposes. Another consideration that real estate investors can use for the sale of real estate investment property is the Section 1031 like kind exchange. This transaction method allows you to sell a real estate investment property and reinvest in a new real estate investment property without recognizing the gain on the sale of the first property. Unfortunately, the sale of a personal residence does not qualify for Section 1031 treatment as a personal residence is not considered an investment property.
There are many considerations to think through as you plan for the tax impact on the sale of your personal residence. Taking the time to research and understand the most likely outcome for the sale of your home will prepare you to make the optimal decision for your circumstances.
For assistance with understanding how the sale of your personal residence is treated for income tax purposes, contact our tax planning experts.
