Many people know the basics of the capital gains tax. Gains on the sale of personal or investment property held for more than one year are taxed at favorable capital gains rates of 0%, 15% or 20%, plus a 3.8% investment tax for people with higher incomes. Compare this with gains on the sale of personal or investment property held for one year or less, which are taxed at ordinary income rates up to 37%. But there are lots of exceptions to these general rules, with some major carveouts applying to residential real estate.
Although the residential real estate market has cooled down of late, your property has likely gone up in value since you purchased it. Eventually, when you dispose of the property, you'll need to determine the income tax consequences with respect to that built-in appreciation.
Maybe you're thinking of selling your home or residential rental property that you own. Or you might unfortunately be experiencing financial trouble and are considering negotiating a short sale of your home with the bank. Other people may have had their home destroyed in a wildfire, hurricane or other natural disaster. If so, continue reading to find out how your gains may be taxed or not taxed in these situations and more.
[Note: The income ranges that determine which tax rate applies to your long-term capital gains – 0%, 15% or 20% – are adjusted each year for inflation. The new figures for the 2023 tax year are expected to be released October or November. For the current capital gains tax brackets, and to see the 2023 brackets when they become available, see What Are the Capital Gains Tax Rates for 2022 vs. 2021?]
Selling Your Primary Home
Many homeowners are aware of the general tax rule for home sales – if you have owned and lived in your main home for at least two out of the five years leading up to the sale, up to $250,000 ($500,000 for joint filers) of your gain is tax-free. Any gain in excess of the $250,000 or $500,000 exclusion is taxed at capital gains rates. (Losses from sales of primary homes are not deductible.)
Here's an example: Say you're married, bought your home in 1990, have a tax basis of $225,000, and are selling the home this year for $700,000. The entire $475,000 of gain is tax-free. Let's now take the same example, but instead of selling the home for $700,000, you sell it for $1 million. The first $500,000 of the gain is tax-free, and the remaining $275,000 is subject to capital gains tax rates of 15% or 20%, depending on your income, plus a 3.8% surtax for upper-income individuals.
To determine your gain or loss from the sale of your primary home, you start with the amount of gross proceeds reported in Box 2 of Form 1099-S and subtract selling expenses such as commissions to arrive at amount realized. You then reduce that figure by your tax basis in the home to come up with your gain or loss.
To figure your tax basis in the house, start with the original cost, add certain settlement fees and closing costs, plus the cost of any additions as well as improvements that add to the value of your home, prolong its useful life, or adapt it to new uses. Cost of repairs or maintenance that are necessary to keep your home in good condition but don't add to its value or prolong its life don't increase your tax basis. Differentiating between improvements and repairs can be tricky, and IRS Publication 523 can help with this.
If you must sell before two years, you may still be eligible for a portion of the exclusion, depending on the circumstances. Sales due to job changes, illness or unforeseen circumstances qualify. The percentage of the $500,000 or $250,000 gain exclusion that can be taken is equal to the portion of the two-year period that you used the home as a residence. For example, say a single person bought a home for $700,000 in August 2020, lived in it for 19 months and sold it in February 2022 for $805,000 after moving out of state for a job. The maximum gain exclusion in this instance is $197,917 ($250,000 x (19/24)). So, the $105,000 gain is fully excluded. You can use days or months for this calculation.
Selling a Primary Home for Which You Took the Home Office Deduction
You may be wondering whether the tax consequences would differ if you took the home office deduction in prior years for using a room or other space in your residence exclusively and regularly for business or rental (e.g., as a home office or the rental of a spare bedroom). It depends.
Generally, the tax consequences are the same whether or not the home office deduction was previously claimed. Gain on the office or rental portion generally qualifies as part of the $250,000/$500,000 capital gains tax exclusion for the sale of a primary home, subject to two exceptions. The first is for so-called unrecaptured Section 1250 gain, which applies if you took depreciation deductions in the past for the office or rental space. (This is discussed in more detail below.) The second exception applies if the workspace or rental space is in a building on the property that is separate from the main home – think first-floor storefront with an attached residence, rented apartment in a duplex, or working farm with a farmhouse on the property.
Selling a Vacation Home
Gains from the sale of vacation homes don't qualify for the $250,000/$500,000 capital gains tax exclusion that applies to the sale of main homes. When you sell a vacation home, your gain will be subject to the normal capital gains tax rules. If you owned the home for more than one year before you sell, then the difference between your amount realized on the sale and your tax basis in the home is subject to a capital gains tax rate of 0%, 15%, or 20%, depending on your income, plus a 3.8% surtax for upper-income individuals.
For example, say you sell a vacation home that you owned since 2005 for $850,000, and you have a tax basis of $725,000. Your $125,000 gain is taxed at capital gains rates. As with primary homes, you can't deduct a loss on the sale of a vacation home.
Selling a Converted Vacation Home
What if you convert a vacation home to your primary residence, live there for at least two years and then sell it? Can you qualify for the full $250,000/$500,000 capital gains tax exclusion? No.
If you sell a main home that you previously used as a vacation home, some or all of the gain is ineligible for the home-sale exclusion. The portion of the gain that is taxed is based on the ratio of the period of time after 2008 that the home was used as a second residence or rented out to the total time that the seller owned the house. The remaining gain is eligible for the $250,000 or $500,000 home-sale exclusion.
Selling a Rental Home
If you hold rental property, the gain or loss when you sell is generally characterized as a capital gain or loss. If held for more than one year, it's long-term capital gain or loss, and if held for one year or less, it's short-term capital gain or loss. The gain or loss is the difference between the amount realized on the sale and your tax basis in the property.
The capital gain will generally be taxed at 0%, 15% or 20%, plus the 3.8% surtax for people with higher incomes. However, a special rule applies to gain on the sale of rental property for which you took depreciation deductions. When depreciable real property held for more than one year is sold at a gain, the rule requires that previously deducted depreciation be recaptured into income and taxed at a top rate of 25%. It's known as unrecaptured Section 1250 gain, the number of its own federal tax code section.
Take this simple example: You bought a rental home for $300,000, deducted $109,000 of depreciation and sold the property for $500,000 this year. The $109,000 of depreciation is subtracted from the purchase price to arrive at an adjusted basis in the property of $191,000. That means your gain on the sale is $309,000 ($500,000 – $191,000 = $309,000). The first $109,000 of your $309,000 gain is unrecaptured Section 1250 gain that is taxed at a maximum rate of 25%, while the remaining $200,000 is taxed at the regular long-term capital gains tax rates.
Note that the unrecaptured Section 1250 gain can also apply to the sale of your main residence if you took depreciation deductions for it in the past, such as from a conversion from a rental home to your primary home or if you had an office in the home.
Capital losses from the sale of rental real estate can offset your capital gains, plus up to $3,000 of other income.
Short Sale of Your Main Home
Some financially distressed homeowners might be considering a short sale of their home. A short sale occurs when your mortgage lender agrees to accept less than the outstanding balance on your loan to help facilitate a quick sale of the property. The tax rules applicable to short sales differ depending on whether the debt is recourse or nonrecourse.
Recourse debt is when the debtor remains personally liable for any shortfall. If the lender ends up forgiving the remaining debt, a special tax rule provides that up to $750,000 in forgiven debt on a primary home is tax-free. The debtor will be taxed on any remaining forgiven debt at ordinary income tax rates up to 37%.
The tax results are different for nonrecourse debt, meaning the debtor isn't personally liable for the deficiency. In this case, the waived debt is included in the amount realized for calculating capital gain or loss on the short sale. For primary homes, no loss is allowed and up to $250,000 of gain ($500,000 for joint filers) can be excluded from income for homeowners that meet the two-out-of-five-year use and ownership tests.
When real property used in a business or held for investment is exchanged for like-kind real property under Section 1031 of the tax code, all or part of the gain that would otherwise be triggered if the realty were sold can be deferred. This tax break doesn't apply to main homes or vacation homes, but it can apply to rental real estate that you own.
The rules are very complicated and tricky, with many requirements to meet. Also, President Biden and Congress have proposed rules to limit the break. Make sure to talk to your tax adviser if you're contemplating a like-kind swap.
Destruction of Your Main Home
If your principal residence is damaged or destroyed in a hurricane, wide-spread wildfire or other federally declared disaster, you'll have gain to the extent the insurance proceeds you receive exceed your pre-disaster tax basis in the home. Up to $250,000 ($500,000 for joint filers) of that gain is excluded from income if you meet the two-out-of-five-year use and ownership tests. Gain in excess of those amounts is taxed at capital gains rates.
One way to delay the tax hit on all or part of the otherwise taxable capital gains is to use the proceeds you get from your insurance company to buy a new home within four years of the disaster. The so-called "involuntary conversion" rules are complex, so, again, be sure to contact your tax adviser if you're thinking about going down this road.
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