Understanding The Real Estate Capital Gains When Selling Your Home

I was reading some blog posts this evening and it became quite clear to me how…well for lack of a better word … ignorant most real estate agents are in regards to the capital gains issue when a homeowner sells their property.

It’s not like the information isn’t readily available. I mean we are Realtors. We are in the business of assisting those who are buying and selling homes. You would think that one would want to offer their client a bit more than … “doesn’t the carpet look great?”

This is the new economy. Buyers AND Sellers are rightfully going to be expecting more out of an agent. It’s time to educate yourselves to the many new facets that we as agents must face on a daily basis.

In addition to knowing how to properly execute a short sale transaction, how about knowing just a modicum of what a Seller may face capital gains wise. While almost everyone is upside down, there may be a few fortunate homeowners out there who need to deal with capital gains issues.

The new capital gains tax law actually went into effect in 1997 and is known as the Taxpayer Relief Act of 1997.

While nothing can be safe financially in the Obama days we are now in, the current capital gains tax law when selling your personal residence allows for an exclusion of up to $250,000 in profit if you are single and $500,000 if married.

In order to be eligible you must have lived in your home for two of the last five years. Again it must be your personal residence and can not be an investment property.

You can use this capital gains exclusion as many times as you like as long as it meets the above criteria. As an example lets say you were fortunate to purchase your home for $400,000 and it is now worth $700,000. Your $300,000 in profit or gain would not be taxed.

So what happens if you are going to make more than $500,000 in profit? Under the current tax plan you would be taxed at a 20% capital gains tax rate on the amount over the $500,000 threshold.

If you sold your main home and made a profit, you may be able to exclude that profit from your taxable income. Here’s how it works.

$250,000 Exclusion on the Sale of a Main Home

Individuals can exclude up to $250,000 in profit from the sale of a main home (or $500,000 for a married couple) as long as you have owned the home and lived in the home for a minimum of two years. Those two years do not need to be consecutive. In the 5 years prior to the sale of the house, you need to have lived in the house for at least 24 months in that 5-year period. In other words, the home must have been your principal residence.

You can use this 2-out-of-5 year rule to exclude your profits each time you sell or exchange your main home. Generally, you can claim the exclusion only once every two years. Some exceptions do apply.

Exceptions to the 2 out of 5 Year Rule
If you lived in your home less than 24 months, you may be able to exclude a portion of the gain. Exceptions are allowed if you sold your house because the location of your job changed, because of health concerns, or for some other unforeseen circumstance.

Change in the Location of Your Job
If you lived in your house for less than two years, you can exclude a part of your gain on the sale of your house if your work location has changed. This exception would apply if you started a new job, or if you are moved to a new location with your employer.

Health Concerns
If you are selling your house for medical or health reasons, be ready to document those reasons with a letter from your physician. Such a letter does not need to be filed with your tax return. Instead, keep the documentation in your personal records just in case the IRS wants further information.

Unforeseen Circumstances
If you are selling your house because of unforeseen circumstances, be ready to document what those reasons are. IRS Publication 523 defines an unforeseen circumstance as “the occurrence of an event that you could not reasonably have anticipated before buying and occupying your main home.” The IRS has given specific examples of unforeseen circumstances:

• natural disasters
• acts of war
• acts of terrorism
• change in employment or unemployment that left you unable to meet basic living expenses
• death
• divorce
• separation, or
• multiple births from the same pregnancy. (wow..so there’s a break for the Octomom!!)

Partial Exclusion

You can exclude a portion of your gain if you are selling your home and lived there less than 2 years and you meet one of the three exceptions. You calculate your partial exclusion based on the amount of time you actually lived in your home.

Count the number of months you actually lived in your home. Then divide that number by 24. Then multiply this ratio by $250,000 (if unmarried) or by $500,000 (if married). The result is the amount of gain you can exclude from your taxable income.

For example: you lived in your home for 12 months, and then sold the home because your employer asked you to relocate to a different office. You are an unmarried person. You calculate your partial exclusion: 12 months divided by 24 month (for a ratio of .50) times your maximum exclusion of $250,000. The result: you can exclude up to $125,000 in gain. If your gain is more than $125,000, you include only the amount over $125,000 as taxable income. If your gain is less than $125,000, then your gain can be excluded from your taxable income.

Loss on the Sale of a Home
You cannot deduct a loss from the sale of your main home.

Reporting the Gain on the Sale of Your Home
Gain on the sale of your home is reported on Schedule D as a capital gain. If you owned your home for one year or less, the gain is reported as a short-term capital gain. If your owned your home for more than one year, the gain is reported as a long-term capital gain.

Calculating Your Cost Basis and Capital Gain
Just like calculating capital gains, the formula for calculating the gain or loss involves subtracting your cost basis from your selling price.

The formula for calculating your cost basis on your main home is as follows:

Purchase price
+ Purchase costs (title & escrow fees, real estate agent commissions, etc.)
+ Improvements (replacing the roof, new furnace, etc.)
+ Selling costs (title & escrow fees, real estate agent commissions, etc.)
- Accumulated depreciation (for example, if you ever took the office in the home deduction)
= Cost Basis

And then calculating your profit or loss would be:

Selling price
- Cost Basis
= Gain or Loss
If the resulting number is positive, you made a profit when you sold your home. If the resulting number is negative, you incurred a loss.
Finally, calculate your taxable gain:

Gain
- Maximum or Partial Exclusion
= Taxable Gain As far as living in the home for two out of the last five years there are no hard and fast rules regarding this. You could have lived in the home the 1st year, rented it the next three, and lived in it again in the last year and you would be fine as far as the exclusion goes.

There is a new law that just went into effect as of January 1st 2009 that closes a tax loop hole in the Capital Gains law. The recently signed 2008 Housing and Economic Recovery act has placed new restrictions on wealthy home owners who own two or more homes and plan to hop from one home to another to avoid paying capital gains. Talk about sticking it to those who actually had the audacity to pay their mortgages!

Some homeowners have avoided paying the capital gains tax by selling their primary home, claiming a full tax exclusion and then moving to a second or third home that they have owned for some time, making it their primary residence and then turning around and selling the home paying little or no capital gains tax.

The new modification says that the gain may not be excluded for periods of “non qualified use”, basically the period of time when the home was not used as the taxpayer’s primary residence.

While being married does offer the benefit of a larger tax exclusion, couples also have some other considerations when it comes to determining whether the home sale is tax-free or not.

Under the law, either spouse can meet the ownership test. For example, the IRS says it’s OK if you owned the home for the last two years, you get married and you decide you want to add your spouse to the title. In this case, lets say the marriage is a year old.

Since one of you owned the residence for the required time, as joint filers you have no problem meeting the ownership test even though your spouse wasn’t an official owner for that long.

Both parties however must pass the use test. Each of the spouses must live in the residence for two years. One thing to note is that the shared use doesn’t have to be while you file jointly. If you and your spouse shared the home for one and a half years before getting married and then six months as newlyweds, the IRS will allow you to claim the exemption. But if your spouse did not move in until the wedding day, you’re out of tax-exclusion luck.

One other thing to keep in mind under this couple requirement is that if either spouse sold a home and used the exclusion within two years of the sale of any jointly-owned property, the couple can not claim the tax exclusion. This means if your new spouse sold their home a few months before the wedding, then you will have to wait two years after that property’s sale date before you can sell your shared marital residence tax-free.

Even if you don’t meet all the home sale exclusion tests there are certain circumstances where you still may be eligible for a tax break. When you need to sell your home because a change in health or a long distance relocation, you may be be able to get a pro-rated tax deduction.

If you pass the requirements of this kind of case, you would calculate the fractional time your were in the home. For example if you were in the home for half the time and were relocated to another state you would be able to claim 12 out of the 24 months of exclusion or half the amount of the exclusion ($125,000).

If you are in the armed services there is also a special provision regarding the capital gains law as well. A law instituted in 2003 now exempts military personnel from the two-year use requirement for up to 10 years, letting you qualify for the full exclusion whenever you must move to fulfill your service commitments.

The information contained here in is believed to be accurate, however every person’s individual tax situation may be different, therefore before acting on the information contained herein, the reader is urged to consult a qualified tax accountant or attorney.

Home ownership certainly has tax advantages. When completing the purchase of a home there are other deductions you need to remember.

Check the following publications for more information on real estate capital gains issues:

• Sale of Your Home (Tax Topic 701)
• Selling Your Home (Publication 523)
• Tax Information for First-Time Homeowners (Publication 530)
• Instructions for Schedule D

sourced in part by Bill Gassett