Note: This article was published on January 11th, 2021 and based on tax law at the time. Tax laws are subject to change.
As financial planners, we often have clients wanting to sell their home. They may be doing it to purchase a larger home for their family, downsizing their home in retirement, or simply deciding to move to another area. At the time of this writing, some housing markets are very hot, and homes are being bought and sold at a rapid rate. In saying this, we often have clients asking about the tax consequence of selling their home.
Your home is considered a capital asset. It is important to understand how capital assets are taxed when they are sold. When capital assets are sold, they may receive different tax treatment than ordinary income (e.g. wages). When an asset with an appreciated price is sold, the gains on the sale (sale price minus cost basis) are treated as either short-term capital gains or long-term capital gains in the year the asset is sold. This is reported on Schedule D of the tax return. A short-term gain is when the asset was held for one year or less. These are taxed at your ordinary income tax rate, which depends on your Adjusted Gross Income (AGI). A long-term gain is when the asset was held for more than one year. Long-term capital gains receive preferential tax treatment and are taxed at either 0, 15%, or 20%, again depending on your AGI.
There is good news. The IRS tax code will allow the capital gains on the sale of your home to be excluded from taxation (not counted in your AGI) under specific limits, if certain requirements are met. This rule is found under “Section 121” of the tax code. If you file “Single” on your tax return, you may exclude up to $250k worth of capital gains from the sale of your home. Likewise, if you file “Married Filing Jointly”, up to $500k of capital gains from the sale of your home may be excluded. The transaction is not reported on Schedule D of the tax return and does not require any additional tax forms.
As previously mentioned, there are certain requirements that must be met to qualify for the Sec. 121 exclusion. One rule is that the home must be considered your principal residence. The taxpayer must have lived in the residence for two years within the five-year period preceding the sale of the home. These two years do not have to be consecutive. Either 24 full months or 730 days will satisfy the two-year ownership and use requirements. A prorated exclusion is available if the two-year requirement is not fully met. It’s also important to note that there are certain exemptions that exist if the two-year requirement is not met.
See below for some common situations regarding Sec. 121 of the tax code:
Jeff is single and bought his home in 2012. The purchase price then was $100k. He has not made any additional improvements to the home. He sells his home for $200k in 2021. This home has been his principal residence every year for the last 9 years. Jeff meets the requirements under Sec. 121 of the tax code, meaning he can exclude up to $250k in capital gains from this transaction. The $100k in gains that resulted from the sale of his home are excluded from taxation. He will not have to report this on his Schedule D or add $100k to his AGI on his tax return.
John and his wife, Linda, bought a home for $600k on July 30, 2020. The homes in this market are rapidly appreciating due to companies opening in the city that offer high-paying jobs. John and Linda find a different home across town that they just cannot resist. They decide to sell their current home for $800k on January 30, 2021, 6 months after originally purchasing the home. They have not fully met the two-year requirement, which would have allowed them to exclude up to $500k in capital gains (married filing jointly). The prorated calculation is as follows: (months lived in home ÷ 24-month requirement) × full exclusion amount. Of the $200k in capital gains from the sale of their home, only $125k can be excluded [(6 ÷ 24) × 500k]. The remaining $75k (short-term capital gain) will be reported on their tax return and be taxed at their ordinary income tax rate.
Jason’s grandmother passes away. She leaves her home to Jason in her will. She bought the home 40 years ago for $50k. The home was valued at $100k on the date of her death. Jason inherits the home via the probate process. Because of this, Sec. 121 of the tax code doesn’t come into play. Under current tax laws, he receives the home with a “stepped-up basis” according to the value of the property at her death, which was $100k. If he sells the home immediately for $100k, he pays no capital gains tax. If he were to sell it in a few months later for $110k, he would be responsible for paying short-term capital gains tax on the $10k of gains.
I hope you found this information informative. Please click here for more information on this topic directly from the IRS website.