Selling your home?
We often receive questions on the tax treatment of capital gains when someone sells their home, especially if the person is not planning on buying another home or is buying a less expensive home. Before 1997, any gains from the sale of a home, in those two circumstances, would be taxed as capital gain. Capital gains were only deferred if the home owner bought another home with a greater value than the one being sold.
In 1997, the tax laws were changed to allow for up to a $250,000 capital gains exclusion for a single person and a $500,000 capital gains exclusion for a married couple, when their home was sold. The capital gains exclusion applies to the profit made upon selling the house. The profit is determined by subtracting the net sales price from the cost basis of the house. The cost basis includes the amount paid for the house plus the costs of any home improvements. If the home was bought for $300,000, and the buyer spends $50,000 on landscaping, drapes and other home improvements, the cost basis is $350,000. Thus, a couple could sell this house for a net sales price of $850,000, and pay no taxes upon the sale.
The capital gains exclusion only applies if one has lived in the house as a primary residence (more than 180 days per year) for a minimum of two years. There are “special circumstances” such as a change in employment, a significant change in health status, etc. that could allow one to sell the house in under two years. A “house” is any residence that has eating, sleeping and toilet facilities, even if it is outside the U.S.
Let’s explore some circumstances when this tax treatment does not fully occur.
1. Your current residence was once your vacation home. Before 2009, it was possible to sell a primary residence, move into a vacation home as your primary residence for two years and then sell the vacation home, receiving the $250,000/$500,000 tax deduction on both home sales. In 2009, the tax laws were changed to significantly reduce the tax saving provided by this approach. Assume that a vacation home was bought in 2009 and converted to a primary residence in 2014 (5 years). If the former vacation home is sold in 2024 (10 years), only two thirds of the profit would be eligible for the long term capital gains exclusion. One third of the profit would be taxable as a long term capital gain.
2. A rental unit in your house. If part of your primary residence is a rental space, upon selling the home, the seller must divide the property into the percentage that is used as a primary residence and the percentage that is rental property. The $250,000/$500,000 exclusion only applies to the percentage of space used as a primary residence. The rental unit percentage is treated as ordinary rental property for tax purposes.
3. Home Office Tax Recapture. If a Home Office deduction has been claimed, the seller is responsible for depreciation recapture upon the sale of a home. If a homeowner has taken a $1,000 annual home office depreciation for 10 years, upon the sale of the house, even if the capital gain is below $250,000, taxes on the $10,000 depreciation recapture are required. Home office depreciation deductions are only a tax deferral. For most people, this deduction may not be worth the short-term tax benefit it provides. However, starting in 2013, a new home office deduction can be claimed which will not require home depreciation nor its recapture.
If your primary residence has never been a second home, used as a rental property or claimed as a home office deduction, the tax treatment upon the house sale is simple. Capital gains taxes be only be required if a single person has a net profit above $250,000 ($500,000 for a couple). However, if the primary residence has previously been a vacation home, a rental property or received home office deductions, it is important that you pay special attention to the methods in which this property will be taxed.