For numerous homeowners, their greatest asset is typically their home. It's a no brainer that at some stage, they may consider selling their property for a myriad of reasons such as relocation, upgrading, or financing retirement.
The tax implications can be profound and can influence the net proceeds that sellers finally pocket after the sale. They can also determine the potential tax contribution you will have to deal with on the sale. With the advent of new tax rules, it's essential to dive into their implications when you choose to sell your real estate asset.
The older rules permitted capital gains taxes to be postponed indefinitely on all past profits, contingent on certain requirements. For instance, if you bought a house for $200,000 and subsequently sold it for $300,000 five years later, there would be a possible capital gains tax liability on the $100,000 profit. But, if you used that profit to purchase a different house worth $325,000 a month after the sale, your tax liability could potentially be pushed forward given that your purchase price exceeded net proceeds and took place within an acceptable timeframe.
With the previous regulations, capital gains from a home sale could be deferred if the money from the sale was used to buy a new principal residence of equivalent or higher value within a two-year time span. Sellers aged 55 or older had the option to exclude permanently up to $125,000 in profits without purchasing another home. However, in 1997 these benefits were shelved when the new rules came into play.
The Taxpayer Relief Act of 1997 marked a significant transformation. This Act eliminated the continuous deferment of profits, replacing it with capped exclusions. The current rules pertaining to the sale of a principal residence permit single taxpayers to exclude profits of up to $250,000 on their home's sale. If you're a married couple filing jointly, you can exclude up $500,000 from your taxable income. Furthermore, the IRS grants homeowners the liberty to utilize this exclusion each time they sell their main residence.
The current deferral rules require homeowners to satisfy two conditions:
But what happens if a couple has lived in the house for just 1.5 years prior to selling it? Since this property does not meet requirements for capital gains exclusion, 100% of the profits are taxable. As many elements contribute to tax legislation, consult a tax advisor if you're unsure about qualifying for capital gains deferral.
Even though saving tax on a $250,000 ($500,000 for joint tax filers) profit is significant, it may be insufficient to fully counter all sellers' gains. Few solutions can serve to amplify your cost basis and cut down your tax liability.
For a house to not be eligible for capital gains exclusion given that it was not a primary residence, there's still the prospect of tax savings through a 1031 exchange.
Here's a hypothetical situation to illustrate how home sale can affect your tax commitment. Suppose that a married couple buys a home eight years ago for $200,000 and sells their home for $1,000,000. The couple qualifies for a $500,000 capital gains exclusion if they file jointly. However, the total profit on the house is $800,000 ($1,000,000 sale price - $200,000 purchase price). Therefore, the couple must recognize capital gains taxes on $300,000 ($800,000 total profit - $500,000 exclusion).
Selling a home is a significant life event. It will likely have a substantial effect on a homeowner's financials and could result in a larger-than-projected tax liability. While the rules have transformed around capital gains recognition, there are ample opportunities to benefit from tax exclusions, deferrals, or exemptions in the process of selling a home.