Capital Gains Tax Rules on the Sale of Your Home

Like buying a home, selling one could be one of the biggest decision in your life. It is important to understand all the rules and factors to consider when selling your home, because knowing what to do and doing them right could save you thousands of dollars. When the time comes to sell your home there are many factors which must be considered in the selling process:

  • Whether or not to use an agent. Enlisting the help of a real estate agent may help you sell faster, but will normally cost you 6%.
  • How to price your home. A low price is painful, but may speed up the process of selling.
  • Buyer requests. Paying for closing costs or repair requests can put a dent in your bank account.
  • Avoiding mistakes. Selling a huge asset like a home leaves lots of room for mistakes.

Photo by The-Tim via Flickr

Of course when all of these expenses are tallied it can be easy to forget the tax man. Let’s take a closer look on how the sale of your home will affect your taxes.

Taxpayer Relief Act of 1997

Exclude a gain of up to $250,000 ($500,000 for a married couple) per home sale without paying taxes.

In May of 1997 the Taxpayer Relief Act became law, easing the tax burden of home sales for millions of homeowners. Prior to this Act, sellers were required to pay taxes on any profits gained in the selling of their home. The only way to avoid paying this tax before the new law was if the money gained in the sale of your home was used within two years to invest in another home which was more expensive than the home you sold. Homeowners age 55 and older had the option to take a one-time only tax exemption of up to $125,000 in profits.

Once the Taxpayer Relief Act of 1997 was signed into law, these exemptions regarding the taxation of profits gained in the sale of a home were not longer needed as current per-sale exclusion amounts became the new law. To claim current exclusions you must first pass the ownership and use test set forth by the IRS. This includes proving you have owned the home for a minimum of two years and lived in that home as your main residence for a minimum of two of the previous five years. With the new rules, a seller can exclude a gain of up to $250,000 ($500,000 for a married couple) per home sale without paying taxes.

Tax Change on the Horizon

The new health care law includes a new tax of 3.8% on “unearned income” that could include capital gains from the sale of your home.

There may be some changes as to how gains from the sale of your home will be taxed in the future. The new health care law includes a new tax of 3.8 percent on “unearned income”. This could include capital gains from the sale of your home.¬†It is important to point out that this new tax is not specifically a “real estate” tax in and of itself. Another important factor to consider is the adjusted gross income (AGI) threshold which determines who would be hit with this additional tax.

For example, individuals selling their home today may be free and clear of real estate taxes from the sale of their home based on profits gained. The sellers income does not play a role in taxation. Under the new law, the same rules would apply regarding the profit threshold; however, high income earners would see additional taxes on profits exceeding the threshold.

There are other stipulations in the new law which allow for multiple scenarios to play out based on AGI and home sale profits. The new changes in taxation of unearned income will not go into effect until 2013. This allows plenty of time for lawmakers to make changes and the IRS to spell out the rules in more detail. Although many sellers will not be affected due to the income thresholds, this remains an important aspect of the new health care reform to which taxpayers should pay attention in the coming years.

Tax Break for Selling Your Home at a Loss

Unfortunately, selling your home at a loss is NOT tax deductble according to IRS publication 523: Selling Your Home. However, there are two work arounds that you could utilize. If you are planning to use one of these methods, it is best to consult a tax professional to make sure that it is a viable solution for you.

First, you can convert your primary residence into a rental property. This means that you have to move out of your house and operate it as a legal rental property. You will have to pay income taxes on your rental property (if it is profitable) and do all the needful activities associated with running and operating a rental. You must also use your house as a rental for a sufficient amount of time. There is no hard and fast rule as to what is considered sufficient, but two tax periods should be enough to seal the deal. If you still wish to sell your house, it will be treated as a capital asset at that time.

Second, if you own your own business or if you are self-employed, you may be able to leverage your house for business use. When you use your house for business purposes, you are allowed certain deductions. When you sell your house, there are additional considerations that you must account for. Unfortunately, it is beyond the scope of this article and the best course of action is to consult a tax professional.

Note that both of these solutions are fairly complicated and they could increase your chance of facing a tax audit.

About the Author

By , on Apr 10, 2011
Tisha Tolar
Tisha Tolar is a co-owner of Trifecta Strategies, LLC and the author of Gen X. When she is not busy being a fiction writer, she writes personal finance articles for several web sites, including Moolanomy.com.

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Leave Your Comment (10 Comments)

  1. john says:

    We are selling our primary home and on the same tax lot is a second home we are selling both homes to the same purchaser do we have to pay any taxes

    • Pinyo says:

      John, your best bet is to consult with a tax advisor. My interpretation is that you can only exclude the gain on one house (the main one you live in) based on what is written on the IRS web site, http://www.irs.gov/publication.....1000200709. I don’t think the fact that they are on the same tax lot (which is defined locally and not at the federal level) matters at all.

  2. J says:

    I have two residences in two states. I split my time between the two houses (I keep a calendar). Spending a little more time in the second state.

    The first state is where I grew up; where my business (self employed) my cars are registered/licensed, my car insurance, health insurance in the first state. (My business is construction–and I have had losses the past two years.)

    In the second state, I have earned income hosting guests/visitors (like a B & B) through sites like VRBO.com–but don’t have a business license, because it is guests visiting my home. My mail comes there for mortgage, cable, internet, utilities, etc.

    I may want to sell the house in the second state this coming year. When I go to sell the house, how do I prove I lived there (slightly) more days, and not have to pay capital gains taxes?

    And, who asks for that information…?

    Can I report state taxes in each satae independently, and Fed from one or the other? (Is that legal?)

    If so, then would having a tax return from the second state help me prove residency when I go to sell?

    Any advice is greatly appreciated.

  3. Ben says:

    On a related topic, many people don’t realize that soon they’ll have to pay taxes on the amount the bank writes off if they sell using a short-sale.

    Talk about adding insult to injury. Also, thanks for mentioning my post on the costs of selling your house!

  4. krantcents says:

    Capital gains tax is intended to encourage investment! That is the reason it is lower than the normal bracket tax. the additional tax is still pretty low that won’t discourage investment.

  5. JMS says:

    Yeah, I read the article. I don’t particularly want to be a landlord, plus I will lose money on the monthly rent. I probably wouldn’t be able to get my mortgage+taxes in monthly rent in my area, even though my payment is relatively low. Plus the hassle of being a landlord.

    Thanks Uncle Sam.

  6. JMS says:

    Wow…so according to this, you can’t take a loss.

    http://www.taxplanning.com/tak.....house.html

    What a joke, tax on the gains, but can’t deduct a loss. You rub my back and I will NOT rub yours.

    Although this is the exact reason I want to sell my house and leave this country in the first place, our greedy, idiotic politicians.

    • Pinyo says:

      JMS – Thank you for digging that up. If you read further, according to the article, there is a loophole. You can either use your house for business or as a rental property for a period of time, then claim it as a business loss.

  7. Steven says:

    It seems that if you can be taxed on the gain you should be able to take a deduction on a loss – a very relevant point in today’s market.

  8. JMS says:

    What about a loss on the sale of your home? What happens there? Would I get to deduct a loss from my income for the year?

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