Selling a home and the taxes involved
With the sharp rise of real estate prices, there are many considering selling their home(s) to capitalize on the growth and lock in the gains. This often brings up the question “how will I be taxed if I sell?”. The rules are quite different when selling a primary home, a second/vacation home, or an investment/rental home. Let’s break it down:
Primary Home Sale
The cost basis of your home is the total of the original purchase price, original closing costs paid, and any improvements paid while owning the home. The gain on the sale of the home is the sale price minus closing costs paid, minus the cost basis. The first $250,000 of gain for single taxpayers, and $500,000 for married filing joint is exempt from taxes. If your gain is larger than the exemption amount, only the amount above the exemption is taxed. If you held the home for more than a year, the excess gain will be taxed at a preferential long-term capital gains rate – either 0%, 15% or 20% depending on your income level. If you held the home for less than a year, the excess gain will be taxed at your ordinary income rates.
The math for calculating the cost basis and gain is the same as a primary home. There is however, no gain exemption. If you held the home for more than a year, the total gain will be taxed at a preferential long-term capital gains rate. If you held the home for less than a year, the total gain will be taxed at your ordinary income rates.
An investment home operates like a business. There are rents collected, expenses paid, and either a profit or a loss reported at year-end. Because the home is an investment asset, the IRS let’s you depreciate it, giving you an annual tax deduction for the reduction in the value of an asset with the passage of time, due in particular to wear and tear. This deduction gives you a current tax reduction benefit but can come back to bite you when you sell if you’re not aware of how it works. Each year you take a depreciation deduction, it reduces your cost basis. A lower costs basis equals a higher gain when the property is sold. Effectively all of the depreciation deductions are “recaptured” and taxed upon the sale of the property.
When the home is sold, the accumulated depreciation is taxed at 25% on the federal. The remaining gain is either taxed at a preferential long-term capital gains rate, or ordinary income rates depending on the home being held for more or less than a year.
Tax Reduction Strategies
Second/Vacation Home: the primary home exemption can be used once every two years. Let’s say you’re selling your primary home and the exemption covers your entire gain. You then have a second home with a large gain. You could move into that home for two years then sell it anytime after that and be able to use the primary home exemption again. This strategy would take two years but would likely prevent you from paying any tax on the home sales.
Investment/Rental Home: You could defer paying taxes on the gain from a sale by completing a 1031 Exchange. In this transaction you take the proceeds and gain from one investment property sale, and you roll it in the purchase of a new investment property. There are very strict rules on how this operates, which I’ll save for another article. This strategy defers the gain into the new investment property and avoids paying current taxes. This can be done as many times as you want. If a 1031 Exchanged home is sold and the proceeds are not invested, the gain is taxable at that time.