If you decided to sell your house to simply life, lock in gains, downsize, or relocate for a job, this article will help you minimize your tax bill.
According to the IRS, most home sellers do not incur capital gains due to the $250,000 and $500,000 exclusion for single and married couples. This makes sense since the median home price is roughly $210,000 in 2018, and the average holding period is nine years.
There are three tests you must meet in order to treat the gain from the sale of your main home as tax-free up to $250,000 / $500,000:
- Ownership: You must have owned the home for at least two years during the five years prior to the date of your sale. It doesn’t have to be continuous, nor does it have to be the two years immediately preceding the sale.
- Use: You must have used the home you are selling as your principal residence for at least two of the five years prior to the date of sale.
- Timing: You have not excluded the gain on the sale of another home within two years prior to this sale.
But let’s say you plan to sell a property in an expensive coastal city where your gains are much greater than $250,000 / $500,000. There’s a good chance you still won’t owe much in capital gains tax if any if you keep proper records.
How To Minimize Your Capital Gains Tax Bill
If you have greater than a $250,000 / $500,000 capital gain, the title company will most likely send you a 1099-S which tells the IRS the final sale price of the home plus any real estate taxes you may have paid. In other words, you must file a 1099-S when doing your taxes, just like how you must file a 1099-MISC for every freelance job you work.
If you haven’t received a 1099-S, call the title company and ask for one so that your records and the IRS’s records match. While you’re at it, ask the title company for the HUD-1 settlement statement or Closing Disclosure from when you purchased your home and for how much. You want to make sure you have the proper date and cost basis in place for when you do your taxes.
Now that you have these important statements it’s time to dig deep into your records to find out how much you spent on construction, renovation, improvements and any special assessments you’ve paid for local improvements. All these expenses INCREASE your cost basis, thereby DECREASING your capital gains and your capital gains tax.
The problem many long term homeowners encounter is NOT keeping proper records of all their expenditure over the years. It’s hard to remember exactly how much you spent remodeling a bathroom 30 years ago. And often times, the company who did work for you may have gone out of business. Hence, contact all your vendors today even if you don’t plan to sell your house for a while.
Always take pictures of each receipt and keep a spreadsheet of all your home improvement work. The spreadsheet should include a date for when work was completed, the description of the work, the vendor, and the cost.
Example Of A Large Home Sale Gain With No Tax Liability
Here’s an example of a $1,800,000 home sale that was originally purchased for $800,000 in 2003. This price appreciation is quite typical in expensive coastal cities like SF and NYC. Despite a handsome $1,000,000 gross profit, the home seller pays $0 federal and state capital gains tax. Study the chart carefully, and let’s discuss the line items below.
Cost to sell: Despite negotiating a total commission cost of 5%, it still costs an absurd $105,000 to sell this $1,800,000 home due to commissions, inspection, 3R and NHD reports, staging, water compliance, and transfer taxes. The transfer tax is particularly arbitrary and onerous for higher priced homes because it is based on a percentage of the selling price, e.g. NY City realty transfer tax: 1% to 2.625% based on +/-$500K home value and type of property. Just remember that the costs to sell a home are negotiable between the real estate agent and the homebuyer.
Related: How Much Does It Cost To Sell A Home
Construction, renovation, and home improvement cost: Over a 15 year time period, this homeowner spent $373,000 making their home perfect. It feels wonderful living in a completely remodeled home compared to an aging rental, especially as your wealth and tastes grow over time. Further, almost all the costs are deductible. This is where having records of all your costs over the years is so important.
Related: If You Want To Make Money On Property, Focus On Expansion
Special assessments from the city: $5,000 was assessed by their city to pay for a water treatment plant overhaul and water sewage pipe replacements.
Cost to purchase the home in 2003: Typically, home buyers will pay between about 2 to 5 percent of the purchase price of their home in closing fees. This homeowner paid 1 percent of the purchase price in closing fees due to some negotiating. Here are some typical fees homebuyers may face.
- Application Fee: This fee covers the cost for the lender to process your application. It can often include things like a credit check for your credit score or appraisal as well.
- Appraisal: This is paid to the appraisal company to confirm the fair market value of the home.
- Attorney Fee: This pays for an attorney to review the closing documents on behalf of the buyer or the lender. This is not required in all states.
- Closing Fee or Escrow Fee: This is paid to the title company, escrow company or attorney for conducting the closing. The title company or escrow oversees the closing as an independent party in your home purchase. Some states require a real estate attorney be present at every closing.
- Courier Fee: This covers the cost of transporting documents to complete the loan transaction as quickly as possible.
- Credit Report: A Tri-merge credit report is pulled to get your credit history and score. Your credit score plays a big role in determining the interest rate you’ll get on your loan.
- Escrow Deposit for Property Taxes & Mortgage Insurance: Often you are asked to put down two months of property tax and mortgage insurance payments at closing.
- FHA Up-Front Mortgage Insurance Premium (UPMIP): If you have an FHA loan, you’ll be required to pay the UPMIP of 1.75% of the base loan amount. You are also able to roll this into the cost of the loan if you prefer.
- Flood Determination or Life of Loan Coverage: This is paid to a third party to determine if the property is located in a flood zone.
- Home Inspection: You will likely get your own home inspection to verify the condition of a property and to check for home repairs that may be needed before closing.
- Homeowners’ Insurance: This covers possible damages to your home. Your first year’s insurance is often paid at closing.
- Lender’s Policy Title Insurance: This is insurance to assure the lender that you own the home and the lender’s mortgage is a valid lien, and it protects the lender if there is a problem with the title. Similar to the title search, but always a separate line item.
- Lead-Based Paint Inspection: Covers the cost of evaluating lead-based paint risk.
- Loan Discount Points: “Points” are prepaid interest. One point is one percent of your loan amount. This is a lump sum payment that lowers your monthly payment for the life of your loan.
- Owner’s Policy Title Insurance: This is an insurance policy that protects you in the event someone challenges your ownership of the home. It is usually optional.
- Origination Fee: This covers the lender’s administrative costs. It’s usually about 1 percent of the total loan but you can sometimes find mortgages with no origination fee.
- Pest Inspection: This fee covers the cost to inspect for termites or dry rot, which is required in some states and required for government loans.
- Prepaid Interest: Most lenders will ask you to prepay any interest that will accrue between closing and the date of your first mortgage payment.
- Private Mortgage Insurance (PMI): If you’re making a down payment that’s less than 20% of the home’s purchase price, chances are you’ll be required to pay PMI. If so, you may need to pay the first month’s PMI payment at closing.
- Property Tax: Typically, lenders will want any taxes due within 60 days of purchase by the loan servicer to be paid at closing.
- Recording Fees: A fee charged by your local recording office, usually city or county, for the recording of public land records.
- Survey Fee: This fee goes to a survey company to verify all property lines and things like shared fences on the property. This is not required in all states.
- Title Company Title Search or Exam Fee: This fee is paid to the title company for doing a thorough search of the property’s records. The title company researches the deed to your new home, ensuring that no one else has a claim to the property.
- Transfer Taxes: This is the tax paid when the title passes from seller to buyer.
- Underwriting Fee: This also goes to your lender, covering the cost of researching whether or not to approve you for the loan.
Phew! That’s a lot of fees. No wonder why the real estate market has powerful lobbyists to keep transaction costs high. In hot real estate markets, some homebuyers will skip the home inspection, appraisal fee, origination fee, pest inspection, application fee and more because they are paying cash and need to make their offer as competitive as possible.
Profit before exclusion: Without the $500,000 tax-free profit exclusion for married couples, the home seller would have to pay taxes on $499,000 in capital gains. At an 22% total effective tax rate, we’re talking $109,780 in taxes. If the couple was in the top marginal tax bracket, they would have had to pay a 20% federal tax rate + 13% state tax, or $164,670 in taxes. But thanks to the tax-free profit exclusion and all the costs associated with the home, the tax liability is $0.
Net proceeds after tax: The seller walks away with $895,000 in net proceeds, which is fantastic considering the seller put down only $160,000 in 2003. Of course, the home improvement expenses cost them $373,000 over a 15 year time period, but they gained tremendous lifestyle value. If we add the downpayment to the home improvement costs, the home seller still comes away $362,000 richer while having lived in an awesome home all those years.
Compare a $362,000 gain with a $1,080,000 loss if you were to rent the house for $6,000/month on average for 15 years. That’s a $1,442,000 swing! Now you can see the wealth building power of homeownership over time. Hopefully, the renter invested their cash flow wisely during this time frame.
Related: Why Real Estate Will Always Be More Desirable Than Stocks
Adjust Your Income And Expenses If You Plan To Sell
If you plan to sell your home in the near future and know you will likely have a large capital gain, then it’s best to make as little W2 or 1099-MISC income as possible. Once a couple’s income is over $250,000, they’ve got to pay an additional 3.8% Net Investment Income tax (Form 8960) on every dollar above $250,000, as well as the higher marginal income tax rate. The income threshold is $200,000 if you are single.
Here’s an example where a single person made $141,827 in net investment income from his home sale and various stock sales and $167,724 in W2 and 1099-MISC income for a total MAGI of $319,551. Given the income threshold is $200,000, he has to pay an additional 3.8% NII tax on $119,551, or $4,543. What a bummer.
If this individual did more proper planning, during the house sale year, he could have worked less, increased his business expenses, pushed out his 1099-MISC freelance income to the following year, asked for his December paycheck to be paid in January, and deposited as many freelance paychecks in the following year as well.
Business owners have much more flexibility in adjusting their income than day job workers, which is why I encourage everyone to start their own.
Other Considerations
If your property sale was a rental property, then you can consider doing a 1031 Exchange where you defer capital gains tax indefinitely. But for a primary residence, understanding the tax laws and keeping great records are what will save you a ton in capital gains tax when it comes time to sell.
With a large financial windfall, you can utilize the proceeds to buy a nicer home in a lower cost area of the country or world. If not, you can reinvest the proceeds in completely passive investments and rent to keep things simple.
Just remember that you can take advantage of the $250,000 / $500,000 tax free profit rule every two years until the rule changes. Thank goodness the government is on the homeowner’s side.
Recommendation
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Hello,
Looking for some desperately needed info.
My husband has a rental property in CA, looking to sell for $340k, he purchased it in 2007 for $237,500 (only in his name, purchased before we got married). We have not lived in either unit of the duplex in the past 5 years (well, we have stayed a couple summers and winters when the units were empty). We have made improvements tallying over $30,000. after paying the 5% broker fee and any other hidden costs, Lest assume it’ll cost us around $18000, what portion do we get taxed on? Is it $340,000-30,000-18,000-237,500=54,500. Would we have to pay recapture depreciation, Ca tax and a federal tax? Is there any other tax I’m not aware of? And is it calculated on the $54,500 capital gains? I know that we have tax brackets, and I believe based on our income we are in the middle, but I’m trying to figure out some numbers before we list the home. Thanks for your time, looking forward to your response.
I purchased my condo in 2017 for 120,00 Hope to sell for 150,000.
Only large replacement was a hot water heater, Paint, light fixtures
Would I need to pay capital gain
If it was your primary residence, then probably not because you have that $250,000 exemption which would be more than your condo is even worth. I think you’re fine.
I have owned my home for 6 years with my husband. We filled for divorce last month but it won’t be final for 5months+. How does it work for the tax break??? Do we have to stay married at the time of the sale for the 500k break or could we get 2 – 250k (one break each) if we are legally divorced by the time of sale? Also, is our marital status based on time of sale or when we file taxes at the end of the year we sell the house in (2020)
Any advice is very much appreciated. Pretty lost over here. Yay divorce =(
Question I have a property that has been a rental for 8 years. I am selling it and should make profit about 80,000. I am married. Will I have to pay capital gains on that? Also is there a way I won’t pay the capital gains if I reinvest the money into paying off my current home?
My Mom has owned her house since 1992. The last 6 years, she has been living in an Assisted Living facility for medical reasons. We have been renting her house to pay for AL. We now are forced to sell the house because we are running out of money. I know that time spend in a facility licensed to treat her condition qualifies as months towards the 2 of 5 year residence requirements, HOWEVER, does renting her home nullify this qualification? Also, she has been out of her home for 6 years. Thanks. My CPA cannot find a clear answer to this.
BTW, I assume you know that I am asking about the Capital Gains residency requirement.
If my mom’s house was quit claimed to me, can I quit claim it to four siblings? I m not interested in profit . I don’t want to pay taxes on a house sale.
We have to sell my aunts house, inherited from her mom in 1968. Worth about 1.4 million now. She is in a rest home paying 6k a month. Her income is minimal, about 24k a year.. We are basically forced to sell to pay for her residential home care.. Is there any way around paying capital gains on her profit which will be over 1.3 and a massive check.
thanks
Hello. Another option would be to rent the home and take the proceeds from the rental to pay her nursing home fees. That is what I have instructed my children to do…and then when I pass on, they inherit the house. Or….how about reverse mortgage??? That would give her the funds she needs to pay for her care, charged against the equity in the home. Good luck!
Believe it or not if the owner selling a home has an income less than 38K annually will pay ZERO long term capital gains on the sale of their property no matter how much equity is in the property so long is it was their primary residence for 2 out of the last 5 years! DO NOT RENT!! That would change the property type and if it were rented for more than 3 years ALL the equity will be taxable! She should sell now and avoid any taxes of her massive check. Talk to a tax consultant and you will find all this to be true!
I bought my house less than a year ago for $395,000. I would like to sell it before the 2yr mark. I plan on breaking even. Would I have to pay a capital gain?
If you break even, what would your capital gain be? Zero. What is the taz on Zero, regardless of the rate? Zero. So, no, you would not have to pay capital gains on it.
I have a house I bought for 175,000. I lived In it for 2 years before I moved. I rented it out after that for about 3 years. Then it sat empty while I remodeled It before putting it on the market. Owned it for about 6 years, rented it out for 3. Sold it for 220,000. Will I be paying capital gains on it? I keep finding that if you live in the house for 2 of 5 years as long as it’s under 250,000 profit I wouldn’t but when I went to my tax person it’s showing I need To pay $8,000 in taxes from the sale and I just Don’t get that.
2 of the last 5 years, not 2 of the 5 years you choose.
I live with my girl friend she’s 67 i’m 64. Her house is in her name only, we plan to sell.
I heard we could use an exemption to get the $500k capital gains break as we meet all other requirements, but we lived together over the past 3 years.
Anyone heard of this–for live in partners?
Thanks in advance…
Ted
If I have little records of the expenses, and no record of the purchase, what do I do when I sell?
Is there exclusion if ownership test was not met (under 2 years), but the sale was due to job relocation? Also what property section classification would this be considered?
There used to be, but it was deleted from the tax code a couple years ago.
The capital gain rules when selling a primary residence has been changed from living in the home for two of last five years to five of last eight years. Article requires amending.
You’re welcome to live in your house for five of the past eight years, but you might regret the last three years if you wanted to move. Feel free to check the rules again.
There are ways to legally defer the capital gain taxes, without doing a 1031 exchange.
Even on your primary home, business or rental propert(ies). No need to get back into real estate if you don’t want to. Remember knowledge is not power, the implementation of knowledge becomes power. Always think of a librarian, they are surrounded by knowledge, but they are not the most powerful people….
i have a horrible feeling now – we bought or home 40 years ago fro 150k – now its worth a million
that million – all of it was going to go into the purchase on a house of like value – a Million.
I had always thought that when you sold your primary residence and bought a new primary residence – there would be no tax on the sale as it would be a wash. This sale and purchase was to done in a fixed amount to time to qualify
thanks
Look at the rules for a 1031 Exchange where you roll forward your gains.
I don’t believe you can utilize a 1031 exchange for your primary residence; it is for investment property.
That is correct.
1031 Exchange Rules To Defer Your Real Estate Capital Gains Tax
I recently sold my house. I refinanced multiple times over the years, paying points multiple times. Are the points for all of the refinances included in the cost to buy the house?
I’m 75 and selling my house this year. Purchased for $400000 and selling for $1,6000,000. Unfortunately I’ve refined to pull money out many times over the years so now owe $700,000. I’m not married so will only get the $250,000 exclusion. Property is a townhouse with HOA so have not done miluch in improvements. Who would be the best person to figure my capital gains? An accountant or RE attorney specializing in taxes?
OK I got a 1099-s from a lawyer that handled the selling of my parents house the money was split with 4 of us for 6000 then the lawyer took out closing cost that took all four down to 5900 and the 1099-s is for 6000 will this have to be filed on when I do my taxes s
I am looking at possibly selling a piece of property that is my primary residence. I will make a few million dollars if I sell it. It will be long-term capital gains. Is my understanding correct, that if my wife and I have an income of under $77,200, we will pay zero taxes on the capital gains?
False
Financial Samurai, I thought that as well that as long as I earn no taxable income the year the sale of my home, even if a gain of a few millions, I owe no capital gain tax.
I just sold my home and trying to figure out my tax bill in NY which might be significant. I am a widower who jointly owned my home with my wife who passed 7 years ago. The home was also hit hard by Hurriance Sandy and was in a presidential disaster area. I received money from FEMA and NYS but the money wasn’t enough to cover all the damage. I lost a lot of personal items in the hurricane. My wife and I made a number of improvements over owning the home for 40 years but unfortunately don’t have all the records due to Hurricane Sandy. Is there a way to deduct some of these home improvements as well as personal items under casualty losses. Thank you.
Hi! Hoping you could help, if instead of a house it was multifamily and the capital gain was +2.5m what can I do in order to lower my taxes if I already gave up my 1031 ex (being a seller’s market at the time).
Any advise?
Thanks!
S.
We moved across the country from Vegas and turned our previous primary home into a rental July of 2017. Our net profit will be less than the 250k/500k rule. We initially thought as long as we sold within two years we could avoid capital gains. I was told by our new cpa and a financial planner that once we turned our primary into a rental we would be hit with capital gains and not fall into the two year window. After reading this article now I am not sure. What is correct. Can you clarify? Thank you.
I believe my article is right. Please send this article to your CPA to read. And then fire your CPA if you’re paying him her money.
And if I’m wrong, please let me know!
We just sold our home of 32 years. During that time, we refinanced three times. Do any of the expenses count in the basis other than the last refinancing? I remember your fence example; is this similar?
I’m getting married this year and my fiancé owns a condo that has gone up in value, slightly less than the 250,000 limit. We did not live together beforehand. Does us getting married preclude him from the excemption if he sells it this year since I have not lived in it for 2 years? If neither of us live in it after we get married, when does he need to sell it by to still qualify for the exemption?
Yes, he still gets the $250K limit if he’s lived in the house 2 out of the past 5 years. You must live wit him for 2 out of the next 5 years to get a $500K tax free benefit.
If neither of you live in the condo, you’ve got 5 years max until your tax free profits run out.
Can 2 joint owners get $500,000 capital gains exemptions when they sell the house that they bought together?
Or the exemption rule only applies to married couple?
Love this site and the incredible posts.
Having recently sold a home for a rather significant ‘gross profit’ I made sure to do all of my research to make sure I adjusted the basis and the costs of selling appropriately.
I’m all for following the tax code and making sure to not pay an extra dime – fair is fair.
But fair is not the same as unintentional (or even more so willful) fraud.
As such, IMO, it’s important to make sure to follow the IRS guidelines on this topic.
https://www.irs.gov/publications/p523#en_US_2017_publink100010751
In that publication it clearly delineates which items from a home purchase (and sale) are allowed and not allowed to be factored into basis or sale costs.
For example:
Some settlement fees and closing costs you can’t include in your basis are: …
Charges connected with getting a mortgage loan, such as:
Mortgage insurance premiums (including funding fees connected with loans guaranteed by the Department of Veterans Affairs),
Loan assumption fees,
Cost of a credit report,
Fee for an appraisal required by a lender,
On the basis side…
Examples of improvements you CAN’T include in your basis. You can’t include:
Any costs of repairs or maintenance that are necessary to keep your home in good condition but don’t add to its value or prolong its life. Examples include painting (interior or exterior), fixing leaks, filling holes or cracks, or replacing broken hardware.
Any costs of any improvements that are no longer part of your home (for example, wall-to-wall carpeting that you installed but later replaced).
Any costs of any improvements with a life expectancy, when installed, of less than 1 year.
Look, we each can file the tax return we want to file, and simply think of it as a negotiation with the IRS, but it would be factually incorrect to state that all selling and buying costs listed in this post and things like repainting can be factored into how to determine the net cap gains (ie selling and basis adjustments).
Paying our lawful and full share of taxes is part of the deal we make living in this country and the deal we make with our other taxpayers. To each their own, but remember each dollar you don’t pay that you are supposed to pay has an impact on everyone else. Will the IRS catch you? Probably not. I just hope that isn’t the advice being given in this post.
I doubt it is…
I bought my city condo 4.5 years ago and lived there as my primary residence for 1.5 years. I had a fire in my condo that resulted in total loss to the entire 7-unit building. Unfortunately due to incompetence and malfeasance on the part of the GC it has taken almost 3 years to rebuild. In the meantime, I have had to find alternative living arrangements. Do any accountants have opinions on how the 2 out of 5 year rule would apply to my case if I wanted to sell today?
Great summary Sam! I can’t think of much else, always scan your receipt right away to a place where you process it later, or put paper receipts in a special place in your wallet, purse etc., then record and file them. If I make an internet purchase i record those in the spreadsheet right away (also remember staging is deductible). I scan with the Dropbox app then record them whenever I file my scans.
Also, working with landscapers/contractors. A lot of those dudes don’t like paperwork, especially if its a one man shop: you gotta make them do it. It’s already easy to get confused when they come back on 15 different days. Keep things real clear with them and well recorded. Demand a daily log of what was done, and if they are time and materials, close out every 2 visits or so. You don’t want a huge bill to arrive that’s impossible to verify. This helps you keep records of all the payments. I’ve had to write the receipt out then have them sign it because they just want to get paid in cash and do verbal estimates. Make them write you up one of those receipts on a form/pad with carbon copy, and take a pic of it and the check, straight into dropbox. If they really want cash, make the check to ‘cash’ (this can be a red flag though, that they might not be licensed bonded and insured.) If you get this system down you will never have to rely on a fallible memory.
I also number all the electronic files by date: “180419-contractors-drainage” etc. so that they sit in the electronic folder in chronological order and are easier to reconcile with the spreadsheet.
Also, this is a huge tip that I forgot this time around, dang. Open a new credit card (points!) or even just a little checking account and pay for EVERYTHING FROM DAY ONE religiously on that card that is deductible for the house. I even write on the card what it’s for in sharpie, because remodeling involves a lot of details!
Great article on the details of expenses of buying/selling a home and capital gains tax impact.
The article and some comments here mention the 2 out of 5 years.
The article says:
“Ownership: You must have owned the home for at least two years during the five years prior to the date of your sale.”
This might be a silly question, but how can you NOT own a home before you sell it? Should this be “lived in 2 out of the 5 years”? Or am I missing something?
It could be clarified in the reverse: you are allowed to have rented it 3 out of the last 5 years, and still have it considered your home for the purposes of this tax rule.
I have never been questioned but I’ve only ever sold 1 home.
In your example yes, if you improve your home with an awesome new fence then the cost of that fence can be added to your basis. The point I was trying to make is that if in order to build that awesome new fence, you first had to remove a fence that you had built in Year 1 after you bought the home, you have to subtract out the cost of that fence (assuming you had added it to your basis to begin with).
Year 0 – cost of home: $100,000
Year 1 – install fence: $ 10,000
Year 15 – replace Year 1 fence with awesome new fence – $20,000
Your basis is $120,000, not the combined $130,000, as the Year 1 fence is no longer part of your home.
From the IRS Pub 523, page 12:
“Any amounts you spent on construction or other improvements that are still part of your home at the time of sale (not including costs of maintenance and repairs). See Basis Adjustments—Details and Exceptions.”
The key part being “still part of your home at the time of sale.” I don’t work for the IRS but I am a CPA.
Right, anything you do that keeps the house at the same level of usability/value is excluded from getting a tax writeoff. Such as replacing that hot water heater with one that is not a big upgrade, fixing a crack in a driveway that cracked while you were living there (as opposed to having the old concrete drive pulled up and replaced with pavers), and so on.
The deduction is for improvements. Landlords do have the advantage there as they can deduct them as a business expense. They can also depreciate the property (which seems somewhat odd, at first, as most real estate in most markets only appreciates in the long run, unless it’s a trailer home or some such). On the other hand, most places give resident-owners a partial tax exclusion, sometimes called a homestead exemption, which may also be even better if the resident-owner is a veteran, disabled person, or a senior citizen. Not a CPA but I do have an MBA, heh.
Good stuff Brian. Thanks for sharing this example.
Luckily I think it’s a pretty rare example! Hopefully, do it right the first time.
Apologies if I missed it in your article, but it’s a potentially expensive oversight not to mention the partial exclusion. See page 5 of https://www.irs.gov/pub/irs-pdf/p523.pdf.
Read it carefully to make sure it applies, but if you don’t meet the Eligibility Test, you may still qualify for a partial exclusion of gain if the main reason for your home sale was a change in workplace location, a health issue, or an unforeseeable event. IF you qualify for the partial then you apply a formula that basically prorates the time you were in residence, owned the house, or the time elapsed since you last used this exemption (whichever is smallest). For example, a single person forced to take a job more than 50 miles away after only six months in the home can still exempt $62,500.
Don’t feel too badly. My accountant didn’t know about it either and just about gave me a heart attack when I saw my proposed tax return. Saved myself a bundle when I pointed this out.
So far as the 1,000,000 dollar figure for profit? In your example half of that was for upkeep and improvements which, treating the house as an investment, is pretty much necessary. For a myriad number of reasons, Uncle Sam (and society in general) should not want to encourage people to rent over owning, which it would be doing if landlord-owners could claim these expenses while tenant-owners could not. As for the exclusion? Used to be you had to use all the money from a sale within six months on a new home or the unused portion would get taxed. This came down unnecessarily hard on people moving from expensive areas to inexpensive areas, old people who were moving to an assisted care arrangement, couples looking to downsize (especially after all the kids moved out), and created all kinds of special rules dealing with people moving overseas to work, et cetera.
One point of clarification I would add: if you make an improvement to your house, like say a $10,000 fence in Year 1 – that gets added to your cost basis; however, if 15 years later you replace the fence because it has rotted and put a new fence in for $20,000 – you can add the $20,000 to your cost basis but you must subtract the $10,000 you previously added for the replaced fence. So your net increase in basis is $10,000. You don’t get to double count.
Ah, but you who is to save you didn’t improve your house with a new security deterrent next level fence with pre-installed cameras and electronic shocks? This is a material improvement.
Have you ever had the IRS question you on a home improvement?
one useful upshot is to be careful to note how it was an improvement. i forgot about this, thanks crowd. :)
Hi Sam and fellow readers,
I read from New York law jounal of following in regards to LTCG:
“The law, though, may change which rate you pay. In the past, the rate was based on your tax bracket. Taxpayers in the 10 percent and 15 percent brackets paid 0 percent, and those in the top tax bracket paid 20 percent. Now, the rate will be based on income thresholds. For 2018, the 0 percent rate for long-term gains and qualified dividends will apply to taxpayers with taxable income that’s less than about $38,600 on individual returns and about $77,200 on joint returns. Taxpayers with taxable income that’s more than those amounts but less than $425,800 ($479,000 for married couples) will pay 15 percent, and taxpayers with higher income will pay 20 percent.”
If I read it correctly, as of 2018, if one’s taxable income is lower than $38,600 (not including LTCG,) one pays 0% on LTCG.
Is this correct? Any comments?
but your gain from the sale of the house will push you into a higher bracket
Aren’t income and capital gains two separate things?
only on the first increment of ~30k. the gains push you up into the next bracket. I know, lame.
Sam, with the real estate market being so inefficient in terms of realtors and selling and fees. I think everyone would love to hear or know how you found the right person to sell your place or what can be done to limit costs since it can be so high in a HCOL area where values of properties are so much higher so more costs!
Huge tip!
As a homeowner for about a year, I was not keeping meticulous records for this purpose… But I’m sure going to start now before those receipts are lost to the sands of time. I’m sure the appreciation/inflation on a 600k house will make this worth it if I stay long enough and the law doesn’t change.
Thanks.
Good call on calling the title company to get the closing costs etc from when the home was purchased. What a great idea! Most people won’t even think of that (but hopefully kept good records)…
Thanks Samurai for article…..In 2017 we sold rental property gifted by our parents that was fully depreciated prior to the gift date. One CPA advised that there’s an existing rule where home improvements can be estimated to determine cost basis. Both parents are deceased so some records are on file but not all. Are you aware of how the estimate process works?
Good post, the only thing I would add is if you are taxed on the sale of a home, you’ll need to file a Schedule D and/or a form 8949. This is where you would include “cost basis” which includes the cost of the house plus the cost of any improvements.
Do you get any deduction if you buy a new house using the profit?
not unless you are doing a 1031 rollover which is for rentals
I am missing the obvious here. In the example, the homeowner actually spent all that money and hence he/she was able to apply it against the profit. But If she didnt have any of it, then I don’t see how she escapes the taxes on the gains.
That’s exactly right.
The deduction is one of the reasons why homeowners spend money to improve their homes. The other reason is to improve the quality of their life while living in the home.
Sometimes you get 80% of your money back on your remodel, sometimes you get 200% back when you expand and the cost of construction is cheaper than the cost to sell.
Now compare the benefits a renter has.
The main point of buying a home is to prove the quality of your life and find stability. If you so happen to make a huge capital gain, that’s a bonus, especially if you don’t have to pay taxes.
The key here is to borrow the renovation costs (and sell quickly within 2 years) then you have really won. Because you wrote off the expenses (which were incurred but borrowed) and you got the 500K exemption.
We did this on our last rental and paid no taxes on the sale (no exemption, but the expenses were so high (borrowed, on paper) it negated the profits we made, and we walked away with actual profits. We originally did a 1031 exchange which we re-characterized in our taxes to a regular sale once we saw the expenses number match the profit numbers.
Can you actually share some numbers on how you did this with your rental? Did you really make a profit if expenses were so high?
I have a home in Bend Oregon, where San Fran peeps are moving to in LARGE numbers. I conconverted a rental due to tax law changes.
I will most certainly occupy it for 2 years if the tax law did not change to 5 of 8!
Home arbitrage is very real here in Central Oregon with, dare I say, the infestation of Californians. Good for us money wise, very lousy due to changes in the new residents attitudes and lack of Oregon values.
Thanks for the idea of buying in Oregon! What are some Oregon values that we need to adopt before moving up there?
I do not blame any individual for changing values. It is that large cities make all.of us have anonymity and move much faster.
People walk by with salutations, drive like speed doesn’t matter, tailgate and have ideas anathema to small town rural life. .No ones fault and your money is welcome here too. Recent article about large tech presence coming here and we see it.
I win either way as I have raw land smack dab in the middle of
all this in migration:).
Thanks again for the clarification that the 2 of 5 still stands, boy am I happy!
Edit: People walk by Without salutations. Like saying hello, just an odd but understandable behavior if one comes from bigger citities.
You can get Bend “values” in Pendleton, Albany, or Boise ;)
I grew up in CA to an OR mother, and I have been hearing this complaint since 1985 ;)
When something breaks it is a repair and that is not a deductible expense. If you fix a hole in your roof for example. If something is a home improvement such as an upgrade, perhaps a new 30 year roof, then that is deductible.
Very thorough post! Keeping detailed records is one of those things that sounds easy but is harder than it seems with all the time that goes by owning a house. When something breaks and needs repairs that tends to be quite stressful and that in itself makes it hard to remember to keep track of all the details of costs, who you hired, when, etc. since you’re just focused on getting xyz fixed. Lots to think about as a homeowner but worth it in the long run!
I suppose I can kick off the fairness argument on not paying tax on a $1,000,000 gain. Part of the use of government’s tax power is to incentivize individuals into certain transactions or decisions. For example, levying a 10% tax on soda discourages purchases of Coca-Cola, Pepsi, etc., with the goal of reducing childhood/adult obesity. Here, government incentives home ownership by giving a tax break when an individual eventually sells their residence. Although, to be fair, the requirement that you had to have lived in the home for 2 out of the last 5 years smells like a lobbyist addition to me…
From the perspective of buying a home to live in it, then yes, I think the tax break is fair. To me, buying a home is part of the American dream and the tax break certainly fosters that.
But, from a purely investment perspective, I would disagree and say its not fair. Why incentivize one sort of investment over another? Understood that some time must be spent actually living in the residence but the requirement then should be living in the home full time. Period.
Thanks for sharing the detail. I’ve been waiting for this one. I thought the 2 out of 5 years were prorated, but I’m glad it isn’t. This is what we plan to do with our duplex. We’ll move in and live there for a while so we can take advantage of the exception. I really hope it sticks around for a while. Good job!
How goes the home search in Hawaii?
SAS is correct 5 of 8 years to avoid cap.gains in new tax.law!
No, it’s still 2 of 5. 5 of 8 was introduced but not passed.
https://www.google.com/amp/s/www.washingtonpost.com/amphtml/news/where-we-live/wp/2017/12/20/how-the-tax-bill-impacts-homeowners-buyers-and-sellers/
Cool. Which country is this rule for John? Send a link b/c in the US, the proposal did not pass for 2018 and it’s still 2 out of the past 5 years.
I am very sorry if I was incorrect.
I will admit I read the entire tax bill at least twice!
I will look again and would be overjoyed if incorrect!
Sam,
What is the best way not to pay more property taxes than you have to once the renovations are done? I’m putting over $1M into a house but don’t want to pay that much in additional property taxes. Is it all based on the assessments? Is there a way to keep this down legally?
Property tax laws are very state and local dependent. You’ll need to figure out how it works in your location.
Likely your builder’s permits will cause a property reassessment by the govt. Only way to save is not perform warranted improvements, but that is asking for trouble.
In 1998, I added a superfluous window to my attic dormer and was surprised when the assessment jumped dramatically.
you can do a LOT of work without triggering a reassessment. I put about 250k into my home with no reassessment. now, undertaking an addition or something that is obviously a large project may do it, but anything that is resurfacing, basic reinforcements, electrical, painting, redo kitch/bath, walkways, drainage, roof etc etc none of those necessarily trigger one. So conceivably you keep paying same tax the whole way. I think they nudged mine up once.
And Americans say that Europe has a lot of bureaucracy!
This kind of tax code is insane and, as you just shown, it does not net much tax collected either. We have a fixed percentage tax for home transactions, it does not matter who lives in the house or doesn’t, or how much they improved it or not, or how much they make or don’t. You sell something, you get 100 dollars, you pay x% of those dollars in taxes and you move on. No reason to keep receipts from 20 years ago when you bought a lamp(metaphorically) and improved the house.
The buyer is quite capable to realize how much to pay for the house, and if it’s a hovel, you get 10 dollars instead of 100 and the tax is lower.
I’m quite surprised that people in the US put up with this kind of red tape, it has to seriously impact their quality of life in the 6 months before actually selling a house.
If only the US president had to go through 1% of this effort before being allowed to threaten to bomb another country and spark a world war, I think we would all sleep better at night.
I really hope I need to refer back to this post one day. Nobody should pay more in taxes than they have to. I’m perfectly fine with somebody not having to pay taxes on a $1M gain on their primary residence. When you think about it, that gain will likely need to be used to pay for a new residence or rental at an inflated price as well.
If only one person with a $1M gain applies this rule, this post would have a huge impact. Unfortunately, I doubt I’m going to see a > 500K gain on my primary residence anytime soon though.
I thought the lived it in for 2 of 5 years has changed with the new tax law to lived it in for 5 of the last 8 years.
Wow, 5 out of 8? That’s a much higher bar. I’ll check the new tax law. 2 years is nothing. 5 is long…
I may be wrong. It seems that was in both the House and Senate bill, but looking on the Internet now (to verify) it may not have passed. May still be 2. Please check.
Its only 2 still in the final bill
I hate being wrong but in this case, I’m really glad I was. My job forced me to move from South Florida 2 years ago. Company is doing poor, and I’m entertaining other offers that would require relocation, as well as company maybe moving us again. I had thought that I’d have to wait 5 years to recoup any benefit on the house (as I got it at a good price) but am now very glad to know I don’t have to worry about that. Definitely makes me feel better about taking another job with a relocation (on this aspect, family is still another issue).
Whew! Thanks for checking. We plan to move into our rental soon. 2 years is much easier than 5 years.
No doubt it could be a hugeee money maker with the leverage and tax laws in place, just get the timing and general location right and you’re golden with a big check coming. For us, it’s just work for returns we don’t necessarily need. I feel like a gray old goose sometimes instead of a young buck with 3 rentals.
You have forgotten property taxes and insurance?
It’s bundled into the $105,000 “Cost To Sell” line item.
What about annual taxes and insurance?
You don’t get to deduction annual property taxes and insurance, therefore these are not added to your cost basis. They are an ongoing expense, not an improvement to the property.