Homeownership has long been a cornerstone of the American Dream, and through the years, government policy has been created to support it. Incentives have historically included:
- mortgage interest and local property tax deductions,
- first-time homebuyer’s benefits,
- tax credits for low-to-moderate income families,
- partial exclusion of capital gain on the sale of your primary residence.
This last point can be a significant tax break. Before 1997, the sale of a principal residence was completely tax free if you purchased a new residence of equal or greater value. However, with the Taxpayer Relief Act of 1997, Uncle Sam broadened and simplified the home-sale exclusion.
Home Sale Exclusion
Beginning in 1997, single tax filers can now exclude from federal taxation up to $250,000 of gain on the sale of a primary residence, while joint filers can exclude up to $500,000. For example, if a couple purchases a house for $500,000 and sells it for $600,000 after living in it for two years, the $100,000 appreciation is federal tax-free. If this same couple owns the home for longer and sells for $1,100,000, only $100,000 of gain would be subject to federal capital gains tax ($1,100,000 – $500,000 cost basis – $500,000 exclusion).
Criteria for Home Sale Exclusion
To reap the benefit of the gain exclusion, some criteria need to be met. You must have owned the home for at least two years, used it as your primary residence for at least two of the last five years (not necessarily consecutive years), and cannot have used the exclusion for the sale of another house within the previous two years.
Calculating Cost Basis and Gain
The cost basis of your home is your purchase price plus improvements. It’s important to keep good records of improvements and understand how they differ from maintenance. Generally, an expense is added to your cost basis if it adds value to the property, prolongs its life, or changes its functional purpose. An addition or kitchen renovation will be additive to cost basis; appliance repair and painting will not. And if you’ve received a tax credit for any improvements or taken a casualty loss deduction, you may not be able to include the entire expense in your cost basis. Homeowners with unrealized gains from home sales prior to 1997 would subtract this from their cost basis.
The capital gain on the sale is as follows:
Capital Gain = sale price – cost basis – closing costs and fees
As you can see, accurate recordkeeping of your cost basis may reduce your gain upon sale and ultimately help lower your tax liability.
Tax on Sale of Home
Assuming you meet the exclusion requirements and your gain on the sale is greater than $250,000 for single filers ($500,000 for joint), you will owe capital gains tax on the difference between the total gain and exclusion. The rate at which this sum is taxed will depend on your income. There are currently three capital gains tax rates: 0%, 15%, and 20%.
If you own your home for less than a year, barring some exceptions to the rule, you will not be able to take advantage of the exclusion, and your entire gain will be taxed at regular income rates.
A seller may also be responsible for paying a state or municipal real estate conveyance tax. Most US states impose conveyance taxes which are usually a percentage of the sale price. As of the last available data from the National Association of Realtors, of the states that do charge a conveyance tax, the lowest is $2 and the highest is 2% of sale price. The transfer tax can be added to your cost basis.
Lastly, a capital gain on the sale of your primary residence may trigger the 3.8% Net Investment Income Tax (NIIT). Your capital gain above the home gain exclusion is included as net investment income and in modified adjusted gross income (MAGI). You will be subject to NIIT if your MAGI exceeds the following thresholds:
Single or head of household $200,000
Married filing jointly $250,000
If applicable, the NIIT is 3.8% of the home-sale gain above the exclusion or the excess of your MAGI above the income threshold, whichever is less.
Young couple selling starter home
Robert and Rebecca are both professionals in their late 30s with MAGI of $175,000. Now that their daughters are 2 and 4, they want to sell their apartment and buy a house with a yard. They bought their apartment five years ago for $350,000 and made $20,000 in improvements. They sell it for $450,000 and pay their Realtor $22,500. Robert and Rebecca have a net gain of $57,500:
Net gain = $450,000 sale price – $350,000 purchase price – $20,000 in improvements – $22,500 in Realtor fees
Since their net gain is less than the allowable $500,000 exclusion and their MAGI is below the income threshold, the entire gain is free from federal taxation.
Senior couple selling family home*
Jim and Judy have owned and resided in their home for forty years. This is the only home they have ever owned. They are joint filers and have MAGI of $200,000 before the sale of their home. They bought their home for $300,000 and, over the years, made $300,000 of improvements. They sell their home for $1,200,000. The recognized gain subject to tax is $100,000 ($600,000 realized gain less the $500,000 exclusion).
The excess gain also increases Jim and Judy’s total Net Investment Income from $125,000 to $225,000, and consequently their MAGI to $300,000, which exceeds the threshold amount of $250,000 by $50,000. In addition to paying capital gains tax, Jim and Judy are subject to NIIT on the lesser of $225,000 (Net Investment Income) or $50,000 (the amount Jim and Judy’s MAGI exceeds the $250,000 married filing jointly threshold). They will owe Net Investment Income Tax of $1,900 ($50,000 X 3.8%).
Be Aware of This Ruling
In 1999, a couple in California demolished a home they had lived in for 15 years to build a brand-new home. After construction, they ultimately decided to sell the house in 2000 without ever living in the new home. Their total gain (sale price minus original purchase price and construction costs) was $591,406. They calculated they should be eligible for the $500,000 exclusion and owed tax on $91,406. The tax court disagreed and ruled the entire gain should be taxed. The Journal of Accountancy reports, “The court held that Congress intended that the exclusion should apply only when the property sold includes the dwelling that has been used as a principal residence for the requisite period.”
Tax consequences of selling a vacation or rental property are more complicated and not covered in this blog.
To learn about other homeownership factors, read our blogs:
- Does the Tax Cuts and Jobs Act Change Whether to Rent or Buy a Home?
- What Does Your House Really Cost, and Can You Afford It in Retirement?
- Choosing a Place to Live in Retirement.
*modified from IRS website