Tax Aspects of Home Ownership: Selling a Home
Most home sellers don’t even have to report the transaction to the IRS. But if you’re one of the exceptions, knowing the rules will help you hold down your tax bill.
This article will address some of the most common topics:
- Do I have to pay taxes on the profit I made selling my home?
- How do I qualify for this tax break?
- How do I qualify for a reduced exclusion?
- Deciding whether to take the exclusion
- Do I have to report the home sale on my return?
- Figuring the gain on the sale of a home
- What is the original cost of my home?
- What is the adjusted basis of my home?
- Postponed gains under the old "rollover" rules
- Converting a second home to a primary home
It depends on how long you owned and lived in the home before the sale and how much profit you made. If you owned and lived in the place for two of the five years before the sale, then up to $250,000 of profit is tax-free.
If you are married and file a joint return, the tax-free amount doubles to $500,000. The law lets you "exclude" this much otherwise taxable profit from your taxable income. (If you sold for a loss, though, you can't take a deduction for that loss.)
You can use this exclusion every time you sell a primary residence, as long as you owned and lived in it for two of the five years leading up to the sale, and haven't claimed the exclusion on another home in the last two years.
If your profit exceeds the $250,000 or $500,000 limit, the excess is reported as a capital gain on Schedule D.
There are three tests you must meet in order to treat the gain from the sale of your main home as tax-free:
- Ownership: You must have owned the home for at least two years (730 days or 24 full months) during the five years prior to the date of your sale. It doesn't have to be continuous, nor does it have to be the two years immediately preceding the sale. If you lived in a house for a decade as your primary residence, then rented it out for two years prior to the sale, for example, you would still qualify under this test.
- Use: You must have used the home you are selling as your principal residence for at least two of the five years prior to the date of sale.
- Timing: You have not excluded the gain on the sale of another home within two years prior to this sale.
If you're married and want to use the $500,000 exclusion:
- You must file a joint return.
- At least one spouse must meet the ownership requirement, and both you and your spouse must have lived in the house for two of the five years leading up to the sale.
Even if you don't meet all of these requirements, there are special rules that may allow you to claim either the full exclusion or a partial exclusion:
- If you acquire ownership of a home as part of a divorce settlement, you can count the time the place was owned by your former spouse as time you owned the home for purposes of passing the two-out-of-five-years test.
- To meet the use requirement, you are allowed to count short temporary absences as time lived in the home, even if you rented the home to others during these absences. If you or your spouse is granted use of a home as part of a divorce or separation agreement, the spouse who doesn't live in the home can still count the days of use that the other spouse lives in that home. This can come into play if one spouse moves out of the house, but continues to own part or all of it until it is sold.
- If either spouse dies and the surviving spouse has not remarried prior to the date the home is sold, the surviving spouse can count the period the deceased spouse owned and used the property toward the ownership-and-use test.
Members of the uniformed services, foreign service and intelligence agencies
You can choose to have the five-year-test period for ownership and use suspended for up to ten years during any period you or your spouse serve on "qualified official extended duty" as a member of the uniformed services, Foreign Service or the federal intelligence agencies. You are on qualified extended duty when, for more than 90 days or for an indefinite period, you are:
- At a duty station that is at least 50 miles from your main home, or
- Residing under government orders in government housing
This means that you may be able to meet the two-year use test even if, because of your service, you did not actually live in your home for at least the required two years during the five years prior to the sale.
In certain cases, you can treat part of your profit as tax-free even if you don't pass the two-out-of-five-years tests. A reduced exclusion is available if you sell your house before passing those tests because of a change of employment, or a change of health, or because of other unforeseen circumstances, such as a divorce or multiple births from a single pregnancy. So if you need to move to a bigger place to find room for the triplets, the law won't hold it against you.
Note: A reduced exclusion does NOT mean you can exclude only a portion of your profit. It means you get less than the full $250,000/$500,000 exclusion. For example, if a married couple owned and lived in their home for one year before selling it, they could exclude up to $250,000 of profit (one-half of the $500,000 because they owned and lived in the home for only one-half of the required two years).
Would it ever make sense to turn down the government's generosity and not claim the exclusion?
Although it's very unlikely, paying tax on a home sale can make sense if it preserves the exclusion to protect more profit on another home that you plan to sell within two years. Remember, although you can use the exclusion any number of times during your life, you can't use it more than once every two years.
You generally can skip reporting your home sale on your income tax return, as long as you did not receive a Form 1099-S: Proceeds from Real Estate Transactions from the real estate closing agent -- a title company, real estate broker or mortgage company.
To avoid getting this form (and having a copy sent to the IRS), you must give the agent some assurances at any time before February 15 of the year after the sale that all the profit on the sale is tax-free. To do so, you must assure the agent that:
- You owned and used the residence as your principal residence for periods totaling at least two years during the five-year period ending on the date of the sale of the residence.
- You have not sold or exchanged another principal residence during the two-year period ending on the date of the sale or exchange of the residence.
- No portion of the residence was used for business or rental purposes by you or your spouse.
- At least one of the following three statements applies:
- The sale price is $250,000 or less
- You are married, the sale price is $500,000 or less, and the gain on the sale is $250,000 or less
- You are married, the sale price is $500,000 or less, and:
- You intend to file a joint return for the year of the sale or exchange.
- Your spouse also used the residence as his or her principal residence for periods totaling two years or more during the five years ending on the date of the sale.
- Your spouse also has not sold or exchanged another principal residence during the two-year period ending on the date of the sale or exchange of the residence.
Essentially, the IRS does not require the real estate agent who closes the deal to use Form 1099-S to report a home sale amounting to $250,000 or less ($500,000 or less for married couples filing jointly).
You should not receive a Form 1099-S from the real estate closing agent if you made these assurances. If you don't receive the form, you don't need to report your home sale at all on your income tax return.
If you did receive a Form 1099-S, that means the IRS got a copy as well. That doesn't necessarily mean you owe tax on the sale, though. It could be a mistake, or the closing agent might not have had the proper paperwork. If you qualify for the exclusion to make all of your profit tax-free, don't report the home sale. But make sure all your paperwork is in order to show the IRS if it asks.
You have a gain if you sell your house for more than it cost. Ah, but how do you calculate the real cost? For tax purposes, you need to pinpoint your adjusted basis to figure out whether or not you have gained or lost in the sale.
The adjusted basis is essentially what you've invested in the home; the original cost plus the cost of capital improvements you've made. Capital improvements add value to your home, prolong its life, or give it a new or different use. They don't include expenses for routine maintenance and minor repairs, such as painting. Examples of improvements are a new roof, a remodeled kitchen, a swimming pool, or central air conditioning. You add these expenses to your original cost to increase your adjusted basis (which in turn decreases the amount of gain on a sale).
On the other hand, you need to subtract any depreciation, casualty losses or energy credits that you have claimed to reduce your tax bill while you've owned the house. Also, if you postponed paying taxes on the gains from selling a previous home (as was allowed prior to mid-1997 for homeowners who used the profits to buy a more expensive replacement house), then you must also subtract that gain from your adjusted basis. Let's say you bought a house for $50,000 in 1993, sold it for $75,000 in 1996, and postponed the tax on the $25,000 profit by purchasing a new home for $110,000. The basis of the new home would be $85,000 (the $110,000 cost minus the $25,000 of non-taxed profit on the first sale).
The original cost of your home, for most people, is the amount you paid for it.
If you purchased your home from someone else, the price you paid is your purchase price (plus certain settlement and closing costs). Your closing statement should list all of these costs. Don't include items from your closing statement that are personal and routine expenses, such as insurance or homeowner association dues, and don't include the prorated amounts for property taxes and interest.
If you built your home, your original cost is the cost of the land, plus the amount it cost you to construct your home, including amounts paid to your contractor and subcontractors, your architect fees, if any, and connection charges you paid to utility providers.
If you inherited your home, your basis in the home will be the number you use for "original cost." For death’s prior to 2010, your basis is the fair market value of your home on the date of the previous owner's death, or on the alternate valuation date if the executor of the estate elected to value the estate's assets as of six months after the owner's death. If the person died in 2010, special basis rules apply depending on your relationship to the deceased. Check with the executor of the estate, who should be able to provide you with information about the basis of your home.
The adjusted basis is simply the cost of your home adjusted for tax purposes by improvements you've made or deductions you've taken.
For example, if the original cost of the home was $100,000 and you added a $5,000 patio, your adjusted basis becomes $105,000. If you then took an $8,000 casualty loss deduction, your adjusted basis becomes $97,000.
Here's how you calculate the adjusted basis on a home:
Start with the purchase price of your home (as described above)
- Or, if you filed Form 2119 when you originally acquired your old home to postpone gain on the sale of a previous home (back in 1997 or earlier), use the adjusted basis of the new home calculated on your Form 2119. (See Postponed Gains Under the Old "Rollover" Rules section.)
To that starting basis add:
- The cost of any improvements that added value to your home, prolonged its useful life, or gave it a new or different use
- Any special tax assessments you paid
- Amounts spent after a casualty (a disaster such as a hurricane or tornado) to restore damaged property
From that upwardly adjusted basis subtract:
- Certain settlement fees or closing costs
- Depreciation allowed for any business use portion of your home
- Residential energy credits claimed for capital improvements
- Payments received for easements or right-of-ways
- Insurance reimbursements for casualty losses
- Casualty losses (from accidents and natural disasters) that you deducted on your tax return
- Adoption credits or nontaxable adoption assistance payments for improvements added to the basis of your home
- First-time homebuyer credit
- Energy conservation subsidies excluded from your gross income
- Any mortgage debt on your principal residence that was discharged after 2006 but before 2013, if you excluded this amount from your gross income
The result of all these calculations is the adjusted basis that you will subtract from the selling price to determine your gain or loss. This adjusted basis is what's considered to be your cost of the home for tax purposes.
Basis when you inherit a home
If you inherited your home from your spouse prior to 2010 and you lived in a community property state—Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington or Wisconsin—your basis will generally be the fair market value of the home at the time of your spouse's death.
If you lived somewhere other than a community property state, your basis for the inherited portion of the home before 2010 will be the fair market value at your spouse's death multiplied by the percentage of the home your spouse owned. If your spouse solely owned the home, for example, the entire basis would be "stepped up" to date-of-death value. If you and your spouse jointly owned the home, then half of the basis would rise to date-of-death value.
If you inherited your home from someone other than your spouse before 2010, your basis will generally be the fair market value of the home at the time the previous owner died. If the person you inherited the home from died in 2010, special rules apply. Your basis generally is the same as the person you inherited the property from. However, the executor has the option to increase the basis of property passing to a non-spouse by $1.3 million and property passing to a spouse by $3 million. To find out the exact basis of any property you inherit, check with the estate’s executor.
Divorce and tax basis
If you received your home from your former spouse as part of a divorce after July 18, 1984, your tax basis generally will be the same as your basis as a couple at the time of the divorce. So if your former spouse was the sole owner of the home, his or her basis becomes your basis. If the place was jointly owned, you now claim the full basis.
If you divorced before July 19, 1984, your basis will generally be the fair market value at the time you received it.
In the past, you may have put off paying the tax on a gain from the sale of a home, usually because you used the proceeds from the sale to buy another home. Under the old rules, this was referred to as "rolling over" gain from one home to the next. This postponed gain will affect your adjusted basis if you are selling that new home. The tax on that original sale wasn't eliminated, just deferred to some future date.
You can no longer postpone gain on the sale of your personal residence. For sales after May 7, 1997, you normally must choose whether to exclude the gain on the sale of your personal residence or to report the gain as taxable income in the year it is sold. You no longer have the option to postpone paying taxes on the gain by purchasing a more expensive residence.
To see how a rollover of gain prior to the change in the law can affect your profit, consider this example: Let's say you bought a house for $50,000 in 1993, sold it for $75,000 in 1996 and postponed the tax on the $25,000 profit by purchasing a new home for $110,000. The basis of the new home would be $85,000 (the $110,000 cost minus the $25,000 on non-taxed profit on the first sale).
Although the rule that allows homeowners to take up to $500,000 of profit tax-free applies only to the sale of your principal residence, it has been possible to extend the break to a second home by converting it to your principal residence before you sell. Once you live in that home for two years, you have been able to exclude up to $500,000 of profit again. That way, savvy taxpayers can claim the exclusion on multiple homes.
Note: Congress has clamped down on this break for taxpayers who convert a second home into a principal residence after 2008. A portion of the gain on a subsequent sale of the home will be ineligible for the home-sale exclusion, even if the seller meets the two-year ownership-and-use tests.
The portion of the profit subject to tax is based on the ratio of the time after 2008 when the house was a second home or a rental unit, to the total amount of time you owned it. So if you have owned a vacation home for 18 years and make it your main residence in 2012 for two years before selling it, only 10 percent of the gain (two years of nonqualified second home use divided by 20 years of total ownership) is taxed. The rest would qualify for the exclusion of up to $500,000.
For information on figuring out whether you have a gain or loss on the sale of your home, see IRS Tax Topic 703: Basis of Assets. For general information on the sale of your home, see IRS Publication 523: Selling Your Home, and Tax Topic 701: Sale of Your Home.