Selling your house can create an unexpected tax hit, but not for everyone:
The real estate market has seen big changes in the past decade. With the rise of remote and hybrid work, some professionals gained the ability to relocate to more desirable or more affordable locations. Many others need additional space to work and live.
Whether due to newfound geographic freedom, economic pressures or personal reasons, individuals and families across the country have decided to sell their homes — and many of these homes are selling at all-time high prices. If you’re thinking of taking this step, here are some important tax considerations before putting your home on the market.
Under the current federal tax law, Internal Revenue Code Section 121 allows for the exclusion of gain on the sale of a principal residence of up to $500,000 for married couples and $250,000 for single individuals if the home sold was your principal residence for two of the last five years.
You also must not have taken advantage of the gain exclusion on the sale of a personal residence in the two years before the sale of your current personal residence. If the gain on the sale of your personal residence is lower than the gain exclusion amounts, only the amount of the gain on the sale of the principal residence is exempt from taxation.
You may be able to exclude some of the gain on the sale of your personal residence if you owned the personal residence for fewer than two years if your reason for moving is related to a job change, health issues or other qualifying reason. Consult with your tax advisor if you are selling your personal residence prior to the two-year holding period and if you have a qualifying reason for selling the home.
While real estate is generally an appreciating asset, sometimes selling a home represents a loss. Unfortunately, loss on the sale of a personal residence, or any personal asset for that matter, is considered a non-deductible loss. The loss cannot be used to offset gains from other investments.
To determine your gain or loss from the sale of your personal residence, there are four main components to this computation: sales price, closing costs, original purchase price and improvements made during your holding period.
Depending on the U.S. state where your personal residence is sold and where you currently reside, the state (where you sold the home) may require a nonresident income tax withholding at closing based on the gross sales price. Some states will allow for a sale to be exempt from this withholding if the sale of the residence is at a known loss, but other states do not have such a withholding exemption.
For example, Colorado requires a 2% state income tax withholding based on the gross sales price of the sale of a home by a non-Colorado resident, regardless of if there is a net gain or loss subject to the state tax. If a refund of this tax is determined, the refund would need to be requested on a state income tax return filing reporting net gain or loss on the sale of the home.
While the federal tax code and certain states allow generous gain exclusions, there are some situations where some or all of the gain from the sale of a residence is subject to tax.
If you do not qualify for the gain exclusion on the sale of your personal residence, your entire gain will be subject to tax. The holding period of the home will determine if the gain is long-term or short-term.
To qualify for the beneficial long-term holding period tax rate, you must own your home for at least one year and one day. If the gain from the sale of your home is in excess of the allowable exclusion amount ($500K for married couples and $250K for single individuals), the excess gain will be subject to income tax. Because of high prices in the real estate market, there is a high likelihood that more taxpayers will have gain on the sale of their personal residence exceeding the gain exclusion allowed.
In addition to paying income tax on the sale of your personal residence, the gain may also be subject to the 3.8% Medicare surtax on investment income. The Medicare surtax only applies to certain taxpayers with modified adjusted gross income of more than $250,000 for married couples or $200,000 for single individuals. To the extent the gain on your personal residence is exempt from tax, that portion of the gain is not subject to the Medicare surtax.
States adopt their own approaches to taxation on gains from the sale of a personal residence:
You should consult with your tax advisor before selling your home if your home is located in a state that assesses a state income tax.
Outside the gain excluded from income tax, you may have some additional tax considerations to review before you sell your personal residence. If you depreciated part of your home as an office for a small business or as a partial rental, there may be a portion of the gain may be recaptured at a higher rate than the long-term capital gain tax rates.
This recapture would be assessed regardless of if the full gain on the sale of your residence falls under the $500K/$250K gain exclusion amount for federal income tax purposes.
Another consideration that real estate investors can use for the sale of real estate investment property is the Section 1031 like-kind exchange. This transaction method allows you to sell a real estate investment property and reinvest in a new real estate investment property without recognizing the gain on the sale of the first property. Unfortunately, the sale of a personal residence does not qualify for Section 1031 treatment as a personal residence is not considered an investment property.
Maximize your profits by understanding how the sale of your personal residence is treated for income tax purposes. Our tax planning experts can clarify the nuances of the tax code and help you achieve the most beneficial outcome when you sell your home.
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