Do You Have to Pay Capital Gains Tax on the Sale of Your Home?

Do You Have to Pay Capital Gains Tax on the Sale of Your Home?

Because of a house sales exclusion that is included in the Internal Revenue Code, people who have never been married are able to shield up to $250,000 in profits from being subject to the capital gains tax when they sell their primary personal dwelling (IRC).  Gains of up to $500,000 can be excluded from the tax returns of married taxpayers filing jointly. This tax advantage is known as the "home sale exclusion," and its official name is Section 121 Exclusion.

How does the exclusion for the sale of homework?

The difference between the sales price and your basis in the property, which is the amount you paid for it plus certain costs that qualify it, determines whether you made a gain or loss on the sale of the property.  If you purchased your property for the price of $150,000 and then sold it for the price of $350,000, you would have made a profit of $200,000.  Because $200,000 is less than $250,000, you are not required to record any of that money as taxable income on your tax return if you are a single person. This is because the exclusion amount is $250,000. Let's assume for the moment that you were able to sell the property for $450,000.  In this scenario, your gain would be $300,000 after deducting $450,000 from the initial investment of $150,000.  Because $300,000 is $50,000 more than the $250,000 exclusion, you would be required to record a capital gain on your tax return for the year in the amount of $50 000 because the exclusion only applies to the first $250 000. In order to qualify for the tax exemption, homeowners need to demonstrate that they satisfy the residency, ownership, and look-back requirements.  More on this can be found below.

How to Figure Out Your Cost Basis and Gain on an Investment

To figure out how much of a profit you made, take your initial investment and deduct it from the amount that you made from selling the item.  Begin with the amount that you paid for the house itself, then add any additional expenditures associated with the transaction, such as title fees, escrow fees, and commissions paid to real estate agents. Now add the total amount that it costs you to make any significant renovations, such as replacing the furnace or the roof.  Unfortunately, painting the living room does not count as one of those activities.  The term "major" is the one to remember here. Deduct from your total any cumulative depreciation that you might have claimed over the years, such as a deduction for a home office that you might have claimed at some point.  The number that you get is known as your cost basis.  The difference between the sales price of your home and its cost basis would represent your capital gain.  If the number is in the negative range, then you have experienced a loss.  Unfortunately, you are not allowed to take a tax deduction for any losses incurred from the sale of any personal property, including your primary residence.  If the sum that you arrive at is positive, then you have successfully made a profit.  After deducting the amount of your exclusion, the remaining amount, if any, is the gain that is subject to taxation.

The Two Years Out of Every Five Rule

In order to benefit from the home sale exception, the property in question has to serve as your principal residence rather than as an investment.  The residence must have been owned and occupied for at least two of the most recent five years immediately prior to the date on which it is to be offered for sale.  However, the two years do not need to be consecutive, and you do not need to be a current resident of the property in order to be able to sell it.  The "residency test" is another name for this particular evaluation. It is not necessary for your two years of residency and your two years of ownership to coincide with one another.  You could live there for a year, then rent it out for three years, and then move back in for another year's worth of occupancy.  According to the Internal Revenue Service's calculations, the house can be considered your primary residence if you spend this much time living there. This two-out-of-five-year rule can be used to exclude your earnings whenever you sell your primary residence; however, this also means that you can only claim the exclusion once every two years because you must spend at least that much time in a dwelling in order to qualify for the exclusion.  You are not eligible to exclude the gain from another property sale that occurred within the previous two years. 

Exceptions to the Two Years Out of Every Five Rule

If you have lived in your home for less than 24 months but qualify for one of a handful of special circumstances, such as a change in the workplace, a move for health-related reasons, or an unforeseeable event, you may be able to exclude at least a portion of your gain from your taxable income when you sell your home. If you meet the requirements of one of the specialized rules, you may be eligible to compute and make a claim for a partial home sales exclusion depending on the period of time you actually spent living on the property. First, tally up the number of months that you spent in the home, and then split that total by 24.  When this ratio is multiplied by $250,000 or by $500,000 if you are married, you will determine whether or not you are eligible for the double exclusion.  The final number is the amount of the gain that can be disregarded when calculating your taxable income. For instance, you might have lived in your home for a year before you were forced to sell it for a cause that satisfies the requirements.  You are not married at this time.  The answer is half if you divide twelve months by twenty-four months.  Multiply this amount by the maximum exclusion you are allowed, which is $250,000.  The end result is that you can exclude up to 125,000 dollars, which is equivalent to fifty percent of your profit. If you had a gain that was greater than $125,000, the only portion of that gain that would be considered taxable under your tax return would be the portion that was above $125,000.  For instance, if you realized a gain of $150,000, you would be required to file a tax return and pay taxes on $25,000.  If your gain was less than or equal to $125,000, you could exclude the entire amount from your taxable income and avoid paying any tax on it. 

Countable Gaps in Residency Qualifications

You are not required to consider short-term absences from your house as evidence that you are no longer residing there.  You are allowed to spend time away from the property as long as you continue to use it as your primary residence, and you have the intention of moving back in at some point in the future. This includes taking a vacation, traveling for work, or attending school. In addition, if you are compelled to relocate due to external factors that are not under your control, you may be eligible for a reduction or exemption of some of your relocation costs.  For instance, if your place of employment moved and you had to relocate before having resided in your home for the required amount of time (two years), you could be able to exempt a portion of the gain from your taxes.  If you recently started new employment or if your existing employer asked you to relocate to a different area, then you are eligible for this exception. If you are compelled to sell your home due to your health or medical conditions, you need to get a statement from your doctor to document both your illness and the circumstances surrounding the sale of your home. This also enables you to qualify for the exclusion despite living in residence for a period of time that is shorter than two years.  You are not required to submit the letter together with your tax return; nevertheless, you should preserve a copy of it with your personal records in the event that the IRS requires confirmation. You should also keep a record of any unanticipated events that may compel you to sell your house before you have lived there for the minimum amount of time needed by the mortgage lender.  An unforeseen scenario is "an incident that you could not reasonably have anticipated before buying and occupying your main home," as defined by the Internal Revenue Service (IRS).  According to the regulations of the Internal Revenue Service (IRS), unforeseen circumstances include things like natural disasters, a change in job that rendered you unable to pay essential living expenditures, death, divorce, and multiple births from the same pregnancy. Members of the armed forces who are currently serving on active duty are exempt from the residence regulation.  If they are on qualified official prolonged duty, which means that the government has ordered them to remain in government housing for at least 90 days or for a period of time that does not have a set expiration date, then they are eligible for a waiver of the requirement for up to ten years.  They are also eligible for the benefit if they are stationed in a duty location that is more than fifty miles away from their home.  When serving a term that is more than five years outside of the United States, Peace Corps volunteers have the option of pausing the clock on their five-year commitment. 

The Principle of Ownership

Additionally, you are required to have owned the property for at least two out of the previous five years.  Either you can own it during a period of time in which you are not residing there, or you can live there during a period of time in which you do not own it. Take, for instance, the scenario in which you resided in your apartment for two years before moving out, finding a new tenant for it, and then selling it three years after that initial transaction.  Because you will have owned the property for five years and lived there for two, you will have complied with both the residency and ownership requirements for the two-year rule. When on qualified official extended duty at a station that is at least 50 miles from their homes and when they are living by order in government housing, servicemembers have the option of delaying the normal five-year period for up to ten years. This option is available to them when they are also living in government housing.

The Test Involving a Look Back

The look-back test examines the applicant's history of house transactions to establish eligibility.  You are able to claim the exclusion and pass the look-back test if you sold a property within the last two years but did not take an exclusion or if you did not sell a home within the last two years.

Taxpayers Who Are Married

To be eligible for the exclusion, married taxpayers are required to file their taxes as a married couple, and each must satisfy the residency condition of two years out of every five.  However, it is not necessary for both of them to have resided in the property at the same time, and only one of the partners needs to pass the ownership test.  It is not possible for married taxpayers who choose to file separate tax returns to take advantage of the house sales exclusion. In the event that one spouse passes away during the ownership period and the other has not remarried by that time, the surviving spouse is eligible to claim their late spouse's residency and ownership time as their own.

Taxpayers who have been divorced

In the event that you win the property in a divorce proceeding, you may be able to claim ownership of the home as well as the period of time that your ex-spouse spent living there.  In order for you to satisfy both the ownership and residence requirements, you can add these months to the total amount of time you have resided in the area, as well as the total amount of time you have owned the property. 

Indicating the Progress Made

If you realize a profit from the sale of your home that is greater than the exclusion amounts or if you do not qualify for the exclusion, you are required to report any profit from the sale of your home on Schedule D of Form 1040 as a capital gain.  If you have owned your house for less than a year, the gain is considered a short-term capital gain and must be recorded.  If you have owned the property for more than a year, the profit from the sale should be reported as a long-term gain. Gains realized over a period of less than one year are subject to taxation at the same rate that is applied to ongoing income.  The tax rates that apply to long-term profits are more favorable: 0%, 15%, or 20%, depending on the taxable income of the taxpayer.  According to the Internal Revenue Service, the majority of taxpayers pay no more than the 15 percent rate.  The maintenance of precise records is essential.  If you are eligible for the exclusion, you should make sure that your real estate agent is aware of this, and you should be prepared to offer documentation if they need it.  If this is not the case, your real estate agent is required to provide you with a Form 1099-S that details your profit and also provide a copy to the IRS.  This will not prohibit you from being eligible to claim the exclusion; however, it may make things more difficult for you, and you may need the assistance of a tax professional to sort everything out. If you received a Form 1099-S for the sale of your property, you are required to disclose the sale of your home on your tax return.  Make sure that you don't end up paying more in taxes than you have to by seeking the advice of a qualified tax expert.

What About the Option of a Short Sale or a Foreclosure?

It is quite rare that a profit would arise from the terrible circumstances that lead to your lender foreclosing on your mortgage loan or consenting to a short sale. This would be a win-win situation for everyone involved.  However, if your lender "forgives" or cancels any remaining debt on your mortgage after the property is sold, this could result in taxable income for you. This could apply to either of the scenarios described above.

Questions That Are Typically Asked (FAQs)

When I sell my house, do I have to pay taxes on the profit?

You are required to pay taxes on any portion of the sale of your home that does not satisfy the rules for an exclusion related to home sales.  The home must be your principal residence, and you must have owned it and resided in it for at least two of the past five years, even if ownership and residency do not need to occur simultaneously. In addition, the home must be in good standing with the local housing authority.  For a residence that satisfies these criteria, you can exempt up to $250,000 in profits from your taxes (or up to $500,000 if you and your spouse file jointly). 

How often are you allowed to make use of the home sale exclusion?

You are only allowed to make use of the house sale exception once every two years due to the requirements that you must have owned and resided in the home for at least two years and that it must be your principal residence.

How can you qualify for the exemption for the sale of your home?

When you sell your property, you are going to get a Document 1099-S in the mail. This form will have all of the information that you need to disclose on your annual tax return.  Reporting the proceeds from your sale and claiming any exemptions to which you have entitled the use of Form 8949 and Schedule D of the Internal Revenue Service.

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