Low mortgage interest rates over the past several years have spurred home sales nationwide to record levels. The second dynamic is rising home prices. Owning your own home has been one of the best investments over the past five years. Most people selling their home today are realizing large profits. If you sell your home for a profit, what are the tax consequences? Many people mistakenly believe that as long as you turn around and purchase a more expensive home, there are no tax consequences. Unfortunately, this is no longer the case. In May of 1997, under the Clinton Administration, Congress passed a new law that changed the tax rules regarding the sale of your primary residence. Under prior law, if you sold your home and then bought a more expensive one, your gain on the sale was postponed. Then once you turned age 55, you could ‘downsize’ your home one time and owe no capital gains taxes on the first $125,000 of gain.
The new rules take a completely different approach. Now when you sell your home, you can exclude the first $250,000 of gain. Any profit above that amount is immediately subject to long-term capital gains taxes. In order to qualify for this exclusion, you must meet both an ‘ownership’ and ‘use’ test. Here’s how it works: during the five-year period ending on the date of sale or exchange of the home, you must have owned and used the property as a principal residence for a total of 730 days (2 years). It is not a requirement that the ‘use’ days are concurrent and short vacations count as use days even if you rent the home during those periods.
If you are married, filing a joint tax return, you can exclude up to $500,000 if:
· Either spouse meets the ownership test;
· Both spouses meet the use test; and
· Neither spouse is ineligible for the exclusion by virtue of having already taken an exclusion during the past 24 months.
Often, people will use a portion of their home as a home-office and deduct and/or take depreciation for the portion that relates to their business activities. The portion of the sale of the residence that relates to these activities is not eligible for the exclusion. For example, if you claim 10% of your home for business use, when you sell your home, 10% of the sales price would not qualify for the exclusion and would be subject to long-term capital gains taxes.
There are two important footnotes to this law. Firstly, there are a number of ‘hardship’ exceptions to the ownership and use rules including partial eligibility for exclusion for such hardships as change of employment, health reasons, and other unforeseen circumstances such as natural disasters. Secondly, you can repeat this process every two years. This means that you could sell your home today and use the exclusion to avoid owing taxes, buy a new home and two years later sell it and you are eligible for another $250,000 exclusion.
As in the past, it is critical that you maintain accurate records of your cost basis in your home. Most people don’t keep good records, which can create problems when you’re selling your home. What you should do now is set up a home file and collect records of your original closing documents (what you paid for your home) and all bills and invoices of capital improvements. For detailed information about this important law, go to www.irs.gov and request Publication 523.
Stewart H. Welch, III, CFP, AEP, is the founder of THE WELCH GROUP, LLC, which specializes in providing fee-only Wealth Management services to affluent retire