From time to time, I get asked tax questions. A common question is: are there taxes on home sales? The best time to ask this question is not after you’ve sold your real estate but if you’ve already passed the keys onto someone else here’s what you need to know.
So you sold the place you called home. Now what? The usual questions are: Do I have to pay taxes on sales? If I have a gain on the sale do I have to pay taxes or can it be excluded?
You Sold. Now What?
Whether or not you are exempt from tax will depend on your filing status, the amount of the gain, and your occupancy status for the property sold.
In the past there was a provision that you needed to reinvest your gain proceeds into a home that cost the same or more than the one you sold. But that rule went away in the 1990s and was replaced by a new rule.
Under Internal Revenue Code Section 121, you only pay taxes when your gain on the sale of your primary residence is more than $250,000 above your ‘basis’ if you are a single filer, or $500,000 if you are filing jointly.
This rule doesn’t apply to investment property sales or to the gain on that portion of a multi-family rental property that you did not live in as your primary residence.
Your gain is figured by determining your basis. Your basis consists of what you originally paid for the property plus certain closing costs at the time. Then you add in major home improvements (i.e. new kitchen, adding a room, etc.). Then you add in whatever real estate transaction fees you incurred.
To figure out the gain, take your sale price less this ‘basis’. If the difference is less than $250,000 (single filer) or $500,000 (filing jointly), then you will have no tax on any of your gain.
You will need to file a form with your taxes to document this.
Example: Taxes on Home Sales – Calculating Gain on Home Sale
Let’s say you and your spouse bought your home back in 1993 at $157,000. At the time you probably had about $860 in closing costs that count toward basis. Over the years you invested in certain improvements like a new room addition costing you $40,000. Your basis at this point is $197,860.
Now it’s 2016 and you decide to sell. You get an offer that you accept for $553,500. At the closing you’ll receive a check for proceeds net of your mortgage payoff, seller closing costs and real estate commission. Let’s say you had a mortgage of $67,950 and you had to about $2,500 in closing costs (i.e. recording fees, attorney fees, courier charges) and deduct another $33,200 for the real estate commission (about 6%).
At the closing you’ll receive a check for $449,850.
You’re feeling pretty flush but then you think about taxes (unless you were proactive and reached out to your financial advisor before listing the property to model this ahead of time).
How much of this $449,850 check do you now need to set aside for taxes? Your tax planner would tell you that you don’t have to worry about taxes on home sales. Why?
Your updated ‘basis’ is the original purchase price plus the allowed closing costs when you bought and sold plus the cost of that nice room addition. Finally, you add in the real estate commission as part of the selling expenses that add to basis. All of this totals $233,560.
Your gain is your sale price less the adjusted basis. So, in this case it is $319,940 (or $553,500 less $233,560).
As a married couple you have an exemption of $500,000 over your adjusted basis before any capital gains tax applies. Since $319,940 falls well within $500,000, you don’t have any taxable gain.
More than $500,000 Gain?
But if your adjusted gain was more than $500,000, what would happen? Assuming you’re filing jointly and have an adjusted gain greater than $500,000, then you’d have a reportable gain. Assuming you’ve owned the property for more than one year you will be subject to long-term capital gains at the state and federal levels at the rate that applies to your bracket. And in some states like Massachusetts, the tax on gains is high (about 12%).
But if this is possibly the case, then you may want to structure the sale with other options including an installment sale or structured installment sale, Opportunity Zone Funds, or certain estate planning options that involve irrevocable trusts. More on these options in future posts.
To best determine whether or not your property sale is exempt, you may want to speak with a qualified tax planner. You can also review the relevant IRS publication: https://www.irs.gov/publications/p523/ar02.html