Most people know the basics of capital gains tax. Gains on the sale of personal or investment property held for more than one year are taxed at capital gains rates of 0%, 15% or 20%, and 3.8% investment tax for high earners. Compare this to gains on the sale of personal or investment property held for a year or less, which are subject to a tax of up to 37% on ordinary income. But there are many exceptions to these general rules, some of which apply to residential real estate.
The residential real estate market is still hot, and if you’re like most real estate owners right now, your property may have appreciated in value since you bought it. Eventually, when you dispose of the asset, you need to determine the income tax consequences of the built-in appreciation.
Maybe you’re thinking of selling a home you own or a rental property. Or, unfortunately, you may be experiencing financial difficulties and are considering negotiating a short sale of your home with the bank. Other people may have had their homes destroyed by wildfires, hurricanes, or other natural disasters. If so, keep reading to learn how your benefits may or may not be taxed under these circumstances and more.
Selling your first home
Most homeowners are familiar with the general tax rule for home sales – if you’ve owned your primary home for at least two of the five years prior to the sale and the gain is up to $250,000 ($500,000 for joint filers). It is tax free. Any gain above the $250,000 or $500,000 exclusion is taxed at capital gains rates. (Loss on sale of primary housing is not deducted.)
Here is an example.: Say you’re married, bought your home in 1990, owe $225,000 in taxes, and are selling the home this year for $700,000. The total gain of $475,000 is tax free. Now let’s take the same example, but instead of selling the house for $700,000, you sell it for $1 million. The first $500,000 is tax-free and the remaining $275,000 is subject to capital gains tax of 15% or 20%, depending on your income, plus an additional tax of 3.8% for high-income individuals.
To figure out your gain or loss from the sale of your original home, start with the amount of gross income reported in Box 2 of Form 1099-S and subtract selling expenses such as commissions to arrive at your gain. You then subtract that figure from your tax base to come up with your profit or loss.
To estimate your tax basis in the home, start with the original cost, add certain settlement fees and closing costs, plus any additional costs as well as improvements that increase the value of your home, extend its useful life, or repair it. to a new use. Maintenance or repair expenses that are necessary to keep your home in good condition but do not increase its value or extend its life will not increase your tax base. Distinguishing between improvements and repairs can be difficult, and IRS Publication 523 can help with this.
If you had to sell before two years, you may still qualify for a portion of the exclusion, depending on the circumstances. Sales due to job change, illness or unforeseen circumstances qualify. A percentage of the $500,000 or $250,000 gain exclusion that can be taken is equal to the two-year period you used the home as a residence. For example, a single person bought a home in August 2020 for $700,000, lived there for 19 months, and sold it for $805,000 in February 2022 after moving out of state for work. The maximum profit exclusion in this example is $197,917 ($250,000 x (19/24)). Therefore, the $105,000 gain is completely excluded. You can use days or months for this calculation.
Selling the main house where you took the home office deduction
You may think that the tax consequences may be different if you took a home office deduction in earlier years for using a room or other space in your home separately and regularly for business or rental (such as a home office or hobby). bedroom). It depends.
Generally, the tax consequences are the same whether or not the home office deduction has already been claimed. Gains from offices or rentals generally qualify as part of the $250,000/$500,000 capital gains tax exclusion on the sale of a principal home, subject to two exceptions. The first exception is for what’s called the Section 1250 benefit, which applies if you’ve already taken deductions for office or rental space. (This is explained in more detail below.) The second exception is if the workplace or rental space is in a separate building from the main house – a first-floor storefront attached residence, think a rented apartment in a duplex. Or a working farm with a farmhouse on the property.
Selling a vacation home
Gains from the sale of vacation homes do not qualify for the $250,000/$500,000 capital gains tax exclusion that applies to the sale of principal homes. When you sell a vacation home, your gain is subject to the normal capital gains tax rules. If you own the home for more than a year before selling it, the difference between the proceeds from the sale and the tax basis in the home is subject to capital gains tax rates of 0%, 15%, or 20%. Depending on your income and 3.8% additional tax for high income individuals.
For example, say you sell a vacation home you’ve owned since 2005 for $850,000, and you owe $725,000 in taxes. Your $125,000 gain will be taxed at capital gains rates. As with primary homes, you cannot deduct losses on the sale of a vacation home.
Selling a converted vacation home
What if you turned your vacation home into your primary residence, lived there for at least two years, and then sold it? Can you qualify for the full $250,000/$500,000 capital gains tax exclusion? no.
If you sell a primary home that you previously used as a vacation home, some or all of the gain is not eligible for the home sale exclusion. The taxable portion of the gain is based on the proportion of the time after 2008 that the home was used as a second home or rented out during the total time the seller owned the home. The remaining gain qualifies for the $250,000 or $500,000 home sale exclusion.
Selling a rental house
If you hold leased assets, the gain or loss on sale is generally described as a capital gain or loss. If held for more than one year, it is long-term capital gain or loss, and if held for one year or less, it is short-term capital gain or loss. Gain or loss is the difference between the tax basis in the property and the amount realized on sale.
Capital gains are generally taxed at 0%, 15% or 20%, and 3.8% for high earners. However, a special rule applies to the sale of a rental property where you have taken a discount. When real estate that has been held for more than one year is sold at a profit, the rule requires that the previously depreciated value be returned to income and taxed at 25 percent. Unrecaptured is known as Section 1250 gain, its own section of the federal tax code.
Take this simple example: You buy a rental property for $300,000, deduct $109,000 in depreciation, and sell the property this year for $500,000. Depreciation of $109,000 is deducted from the purchase price to arrive at an adjusted basis on the property of $191,000. That means your profit on the sale is $309,000 ($500,000 – $191,000 = $309,000). The first $109,000 of your $309,000 in unrecaptured section 1250 gain is taxed at a higher rate of 25%, and the remaining $200,000 is taxed at regular long-term capital gains tax rates.
Note that the unrecaptured Section 1250 gain can also be applied to the sale of your principal residence if you previously moved from a rental home to your primary home or took deductions if you had an office in your home. .
Capital losses from the sale of real estate can offset your capital gains and up to $3,000 of other income.
Short sale of your home
Some financially strapped homeowners may be considering a short sale. A short sale occurs when your mortgage lender agrees to accept less than the balance on your loan in order to facilitate a quick sale of the property. The tax rules that apply to a short sale differ depending on whether or not the debt is refundable.
Repossession debt is when the borrower remains personally liable for any default. If the lender ends up forgiving the remaining debt, a special tax rule provides that up to $750,000 of forgiven debt on a primary home is tax-free. The borrower pays regular income tax of up to 37 percent on any remaining forgiven debt.
The tax consequences are different for defaulted debt, meaning the debtor is not personally liable for the default. In this case, the canceled debt is included in the amount realized to calculate the capital gain or loss on the short sale. For principal residences, no losses are allowed and up to $250,000 of gains ($500,000 for joint filers) may be excluded from income for homeowners who meet the two-year use and ownership tests out of five years.
When real property used in business or held for investment is exchanged for like real property under Section 1031 of the Tax Code, all or part of the gain from the sale of the realty may be deferred. This tax break does not apply to primary homes or vacation homes, but may apply to rental real estate you own.
The rules are very complex and tricky, with many requirements to be met. Also, President Biden and Congress have proposed legislation to limit the break. Be sure to consult your tax advisor if you are considering a similar exchange.
Losing your primary home
If your primary residence is damaged or destroyed by a hurricane, wildfire, or other federally declared disaster, the amount of insurance proceeds you receive exceeds the home’s pre-disaster tax payment amount. Up to $250,000 ($500,000 for joint filers) of that gain is excluded from income if you meet the two-year use and ownership tests out of five years. Gains above these amounts are taxed at capital gains rates.
One way to defer tax on all or part of taxable capital gains is to use the proceeds from your insurance company to buy a new home within four years of the accident. The rules on “involuntary conversion” are complex, so, again, be sure to check with your tax advisor if you’re considering going down this route.