How is the Sale of Your Home Taxed?

In this post I’ll tell you what you need to know about selling your home and how it’s taxed.

Get a Tax Break When You Sell Your Home

One of the ways the government encourages home ownership (or any activity, for that matter) is by giving us tax incentives. Tax incentives are great because they allow you to keep more of your money, instead of paying it to the government. One of the biggest tax breaks you can get becomes an option when you sell your primary residence—and it has to do with capital gains.

What are Capital Gains and Losses?

So let’s start off by briefly discussing capital gains and losses. You know that you have to pay tax on income from your job, business, or interest you receive from a bank account, for instance—that’s called ordinary income. But you also have to pay tax on profit you make from an investment—that’s called a capital gain.

A capital gain occurs when you sell a capital asset for more than what it cost you. And a capital loss is—you guessed it—money you lose on the sale of a capital asset. Real estate, stocks, mutual funds, and many other types of investments are capital assets. When you make a profit from buying them low and selling them high—bravo! You just created a capital gain!

But what about capital losses? You can offset most capital losses against your capital gains to reduce your tax liability. But unfortunately, that’s not the case with a loss from the sale of your main home. And that’s a question I get frequently. So I want to make sure you understand that when you lose money on the sale of your primary residence, it can’t be “written off” or deducted from your taxable income.

How is a Capital Gain on a Home Calculated?

When you take the difference between the amount you realize from your home sale and the adjusted basis or cost, you’ve calculated the gain or loss. It can be a little complicated, so instead of going into the details here, I’ll refer you to the worksheets found in IRS Publication 523. If the amount you realize from a home sale is more than your investment in the property, then you have a gain. For example, if you realized $215,000 on the sale of your home and your adjusted basis is $200,000, then you created a capital gain of $15,000. But if your basis is less than what you realized, you have a loss that is not tax deductible.

How Much Gain Can be Excluded on a Real Estate Sale?

Even though a capital gain is taxable, the good news is that you can generally exclude all or a part of the gain on the sale of your main home from tax. So how much gain can you make disappear? Well, it’s a pretty big chunk of change—up to $250,000. Or if you’re married and file a joint tax return you can exclude up to $500,000 of gain. A widow or widower, who didn’t remarry before selling their home, also generally qualifies to exclude up to $500,000.

What are the Qualifications to Exclude Capital Gains on Your Home Sale?

The requirements you have to meet to be eligible for the home-sale capital gain exclusion are pretty simple. You must have owned the home and used it as your main residence for at least two of the five years that preceded the sale. The requirement is extended to two of the previous ten years if you or your spouse are eligible government employees, are in the military, or work for the Peace Corps. You can only claim one primary residence at a time, even if you own more than one home. It can be a house, condo, co-op apartment, mobile home, or even a houseboat.

How Often Can You Exclude Capital Gains on a Home Sale?

A really great part of the capital gains exemption for home sales is that there’s no limit on the number of times you can take it in your lifetime. Since you have to live in the home for a minimum of two years to qualify, theoretically you could reap a tax-free gain every two years if you were willing to sell, buy, and relocate that often. It sounds like a good strategy, but just the thought of moving that often exhausts me!

What if You Don’t Qualify for the Capital Gains Exclusion?

If you don’t meet the requirements to qualify for the capital gains exclusion you may still qualify for a partial exclusion. That might be the case if you had to sell your home due to poor health, to relocate (more than 50 miles away) for a new job, or for other unforeseen circumstances, such as becoming unemployed or getting divorced, for instance.
But you’ll have to pay capital gains tax on any amount of gain that you can’t exclude. A capital gain is taxed differently from ordinary income. It’s also taxed differently depending on how long you owned the asset that was sold. Ownership for a year or less makes the transaction a short-term gain. And if you owned the asset for more than a year it’s considered a long-term gain.

The Difference Between Short and Long-Term Capital Gains

The tax rates for short-term capital gains are the same as the rates for ordinary income. But long-term gains get very favorable tax treatment. You pay much less tax for a long-term capital gain than for the same amount of ordinary income. For 2010 the highest tax rate for a long-term capital gain is 15%, but the highest rate for ordinary income goes up to 35%. And the lowest tax rate for a long-term capital gain is actually zero if you’re in one of the two lowest tax brackets. Tax rates for both ordinary income and capital gains are projected to increase after 2010, so be sure to check taxfoundation.org for current information.

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More Resources:
IRS Publication 523, Selling Your Home provides complete rules and worksheets
Sale of Your Home (Tax Topic 701)
Schedule D is how you claim capital gains and losses
Instructions for Schedule D has more information on capital gains and losses

For Sale image courtesy of Shutterstock