Many people know the basics of capital gains tax. Gains from the sale of personal or investment property held for more than one year are taxed at favorable rates of capital gain of 0%, 15% or 20%, plus an investment tax of 3.8% for people with higher incomes. Compare this to the proceeds from the sale of personal or investment property held for a year or less, which are taxed at ordinary income rates of up to 37%. But there are many exceptions to these general rules, with some important exceptions that apply to residential real estate.
The residential real estate market is still hot, and if you’re like most homeowners these days, it’s likely that your property has increased in value since you bought it. Finally, when you vacate the property, you will need to determine the consequences of income tax with respect to this incorporated appreciation.
Maybe you are thinking of selling your home or residential rental property that you own. Or you may unfortunately have financial problems and are considering negotiating a short sale of your home with the bank. Other people may have had their home destroyed in a forest fire, hurricane, or other natural disaster. If so, keep reading to find out how or not your earnings can be taxed in these situations and more.
Selling Your Primary Home
Many homeowners know the general tax rule for the sale of homes: if you have owned and lived in your main home for at least two of the five years prior to the sale, up to $ 250,000 ($ 500,000 for joint taxpayers) of your earnings. it is tax free. Any gain in excess of $ 250,000 or $ 500,000 exclusion is taxed at capital gains rates. See the article : 6 High-tech dividend stocks to buy and hold. (Losses from primary home sales are not deductible).
Here’s an example: Suppose you’re married, you bought your house in 1990, you have a $ 225,000 tax base, and you’re selling the house this year for $ 700,000. The entire $ 475,000 gain is tax-free. Let’s take the same example now, but instead of selling the house 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 a capital gains tax rate of 15% or 20%, depending on your income, plus a 3.8% surcharge for to people with higher incomes.
To determine your gain or loss from the sale of your main home, start with the amount of gross income shown in box 2 of Form 1099-S and subtract the selling expenses, such as commissions, to reach the amount performed. Then reduce this figure according to your home tax base to make your profit or loss.
To calculate the taxable base of the home, start with the original cost, add certain settlement fees and closing costs, plus the cost of any additions, as well as improvements that add value to your home, extend its life. useful or adapt it. to new uses. The cost of repairs or maintenance that is necessary to keep your home in good condition, but which do not add value or extend its life, do not increase your tax base. Differentiating between improvements and repairs can be tricky, and IRS publication 523 can help with that.
If you have to sell before two years, you can still opt for a part of the exclusion, depending on the circumstances. Sales for job changes, illness, or unforeseen circumstances are eligible. The percentage of $ 500,000 or $ 250,000 profit exclusion that can be taken is equal to the part of the two-year period you used the house as a residence. For example, suppose a single person bought a house for $ 700,000 in August 2020, lived in it for 19 months, and sold it in February 2022 for $ 805,000 after leaving the state to work. The maximum profit exclusion in this case is $ 197,917 ($ 250,000 x (19/24)). Therefore, the gain of $ 105,000 is totally 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 if the tax consequences would differ if you took the home office deduction in previous years to use a room or other space in your residence exclusively and regularly for business or rent (e. Read also : Former Hawk County Recorder named state real estate chief.g. ., as a home office or the rental of a spare part). bedroom). It depends.
In general, the tax consequences are the same whether or not the office deduction was previously claimed. Earnings on the part of the office or rent are generally classified as part of the $ 250,000 / $ 500,000 capital gains tax exclusion for the sale of a main home, subject to two exceptions. The first is for the so-called Section 1250 unrecovered gain, which applies if in the past you made amortization deductions for the office or rental space. (This is discussed in more detail below.) The second exception applies if the workspace or rental space is located in a building on the property that is separate from the main house: think of a store in the first floor with an attached residence, a rented apartment in a duplex. , or working farm with a farmhouse on the property.
Selling a Vacation Home
Earnings from the sale of vacation homes do not meet the requirements for the $ 250,000 / $ 500,000 capital gains tax exclusion that applies to the sale of primary homes. When you sell a vacation home, your earnings will be subject to the usual capital gains tax rules. If you owned the home for more than a year before selling it, the difference between the amount made on the sale and your taxable base on the home is subject to a 0% capital gains tax rate. This may interest you : Amazon Prime Day 2022: Offers For Artists And Art Enthusiasts. , 15% or 20%, depending on your income, plus a 3.8% surcharge for people with higher incomes.
For example, suppose you sell a vacation home that you have had since 2005 for $ 850,000 and have a tax base of $ 725,000. Your $ 125,000 earnings are taxed at capital gains rates. As with main homes, you cannot deduct a loss on the sale of a vacation home.
Selling a Converted Vacation Home
What if you turn a vacation home into your main residence, live in it for at least two years and then sell it? Can you opt out of the total capital gains tax of $ 250,000 / $ 500,000? No.
If you sell a primary home that you previously used as a vacation home, some or all of the earnings are not eligible for the home sale exclusion. The portion of the gain that is taxed is based on the relationship between the time period after 2008 in which the home was used as a second home or rented to the total time the seller owned the home. The remaining gain is eligible for the $ 250,000 or $ 500,000 home sale exclusion.
Selling a Rental Home
If you own a rental property, the gain or loss when you sell it is usually characterized as a capital gain or loss. If it is held for more than a year, it is a long-term capital gain or loss, and if it is held for a year or less, it is a short-term capital gain or loss. The gain or loss is the difference between the amount made on the sale and the tax base of the property.
The capital gain will generally be taxed at 0%, 15% or 20%, plus the 3.8% surcharge for people with higher incomes. However, a special rule applies to gains on the sale of rental property for which you have taken amortization deductions. When depreciable property held for more than one year is sold at a profit, the rule requires that the previously deducted depreciation be recovered in income and taxed at a maximum rate of 25%. Unrecovered Section 1250 gain, known as its own section of the federal tax code.
Take this simple example: You bought a rental home for $ 300,000, deducted $ 109,000 in amortization, and sold the property for $ 500,000 this year. The first $ 109,000 of your $ 200,000 gain is unrecovered Section 1250 earnings that are taxed at a maximum rate of 25%, while the remaining $ 91,000 is taxed on long-term capital gains tax rates.
Please note that the unrecovered earnings from Section 1250 may also apply to the sale of your primary residence if you have made amortization deductions in the past, such as a conversion of a rental home to your primary home. or if you had an office in the house. .
Capital losses from the sale of rental property can offset your capital gains, plus up to $ 3,000 in other income.
Short Sale of Your Main Home
Some homeowners with financial difficulties may be considering a short sale of their home. A short sale occurs when your mortgage lender agrees to accept less of the outstanding balance of 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 a resource or not.
Appeal debt is when the debtor remains personally liable for any deficit. If the lender ends up forgiving the remaining debt, a special tax rule provides that up to $ 750,000 in forgiven debt in a primary home is tax-exempt. The debtor will tax on any remaining forgiven debt at ordinary income tax rates up to 37%.
Tax results are different for debt without recourse, meaning the debtor is not personally liable for the deficiency. In this case, the debt waived is included in the amount realized for the calculation of the capital gain or capital loss of the short sale. For main homes, no loss is allowed and up to $ 250,000 gain ($ 500,000 for joint taxpayers) can be excluded from income for homeowners who meet the use and ownership tests of two out of every five years.
Like-Kind Exchanges
When real estate used in a business or held for investment in similar real estate is exchanged under section 1031 of the Tax Code, all or part of the gain that would otherwise occur if the property were sold may be deferred. This tax deduction does not apply to primary or holiday homes, but may apply to rental properties you own.
The rules are very complicated and complicated, with many requirements to meet. In addition, President Biden and Congress have proposed rules to limit rest. Be sure to talk to your tax advisor if you are considering a similar exchange.
Destruction of Your Main Home
If your primary residence is damaged or destroyed by a hurricane, widespread wildfire, or other federally declared disaster, you will have earnings to the extent that the insurance income you receive exceeds your pre-disaster tax base in your home. . Up to $ 250,000 ($ 500,000 for joint taxpayers) of this gain is excluded from income if you meet the use and ownership tests of two out of five years. Gains in excess of these amounts are taxed at capital gains rates.
One way to delay the tax impact on all or part of the capital gains that would otherwise be taxed is to use the income you get from your insurance company to buy a new home within the next four years. to disaster. The so-called “involuntary conversion” rules are complex, so again, be sure to contact your tax advisor if you’re thinking of following this path.
