By Jason K. Branning, CFP
Owning a house has traditionally been seen as part of the American dream. We love our homes for many reasons: the backyard, bonus room or basement, kitchens and location. Home represents many of our aspirations, is the location of many milestone memories, and serves as the largest investment most Americans will ever make. Based on national annual averages, less than 6% of people over age 60 sell their homes. Retirees sell homes for a variety of reasons, of course – they want to downsize, move closer to family, live in an income tax-friendly state, or escape cold winter weather. Yet, according to the Retirement Income Certified Professional curriculum, the primary reason retirees sell their home is due to changing health conditions, which could create significant tax consequences.
Homes Sales in 2021: The Best of Times
Buying and selling homes is burdensome and emotionally charged. There are numerous expenses in a home sale, such as realtor fees, inspections, engineering reports, closing costs, etc. Adding to the burden for many is the reality that selling a home may create a tax on the capital gain on the home’s value.
Late summer 2021, home prices have experienced record growth rates that have exceeded any past home growth rate since 1976. The year-over-year percentage change from 2020-2021 has been about 20%. From a historical perspective, 1980 saw ~15% increase and 2009 ~12% decrease. Trends rotate, of course - what goes up also comes down.
If you are thinking of selling your home, now, more than ever, be sure to calculate the possible tax consequences. It’s important to note that the primary residence is given special tax treatment. But this special treatment does not apply to a second home. The primary residence for IRS purposes is where you spent the majority of your time, the address used for tax returns, driver’s licenses, and bills.
Let’s examine some of the tax basics of selling your home and discuss the factors that go into determining whether you may owe taxes when you sell.
How Do I Know If I Owe Taxes on my Home Sale?
First, the good news. The Taxpayer Relief Act of 1997 added the personal residence capital gain exemption. The personal residence capital gain exemption provides married couples the ability to shelter up to $500,000 in tax-free gains (single, up to $250,000) from the proceeds of the sale of their home.
- Imagine Fred and Sally bought a home in California in 1980 for $150,000. Now, as they are entering retirement, they are selling the family home and relocating to Texas to be near their son and grandchildren.
- Purchased Home in 1980 for $150,000
- Home Sells in 2021 for $900,000
- $900,000 - $150,000 = $750,000 Total Gain
- Exclusion Amount (Married): $500,000
- Taxable Gain on Sale: $250,000 @ 20%
- Estimated Long-term Capital Gains Taxes Due: $50,000
Next Steps If Your Home Sale Has a Taxable Gain
Now, the bad news. There are additional considerations that will have to be researched, as detailed below, which may impact whether a home sale will be taxable and/or at what rate. If you have a second home, are recently married or remarried, or have decided to retire outside the United States, you will need to examine the rule closely.
There are two categories that will automatically disqualify the gain exclusion on a primary home.
- If you received the home through a tax-free exchange (1031) within the last 5 years, the tax exclusion would not be granted.
- If you are subject to expatriate taxes in the case where you are no longer a resident of the United States.
If you own two homes and spend time in both places, you need to make sure to review whether you’ll meet the three tests before you sell. These tests are ownership, use, and eligibility. All three tests must be passed to claim the full exclusion.
Passing the ownership and use tests requires:
- One spouse needs to be a resident of the primary home for at least 24 months (can be non-consecutive) out of the last 5 years preceding the sale.
- Both spouses must meet the use test. While one spouse can satisfy the resident test, the use test requires that both spouses use the home for at least 24 months. The use test exceptions include being forced to move from your primary home due to physical or mental health reasons. The minimum time requirement then drops to 12 months in the home rather than 24 months. The key here is if the move is for documented reasons of health (not well-being).
Eligibility requirements present a final test to ensure you qualify for the exclusion. There is a lookback period. If married, both partners cannot have used the gain exclusion in the last 2 years. There are a few other exceptions that you can examine in IRS Publication 523.
Records, Records, Records
With any financial transaction, always keep records. Records should include:
- Use and ownership start dates (with documentation)
- Evidence showing it to be your principal residence (address used for bills, tax returns)
- If you have two houses, the amount of time spent in each.
Lastly, there is also some allowance for partial exclusion under certain circumstances. A partial exclusion allows you to use a ratio in calculating possible taxes due on a home sale for a location change due to employment, health, or unforeseen circumstances.
If you have questions, always seek the advice of a tax professional to make sure you have all the facts about your specific situation and how these tax rules may apply to you.
About the Author: Jason Branning CFP
Jason Branning is a Certified Financial Planner® practitioner. He serves clients as a fee-only investment adviser and financial planner with Asset Dedication in Ridgeland, Miss. Jason specializes in retirement income planning. He owns Branning Wealth Management LLC and writes about Modern Retirement Theory
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