As the economy is rebounding, and especially the housing market, I feel like this may be an issue on more and more people’s minds.
I had a reader email me this question a few days ago. The gist of their question was just as the title states: Do they have to pay taxes, and more specifically, capital gains tax on the sale of their house? They’ve had the house for a while so the value had increased, they were not underwater.
The answer is: It depends. Exactly the non-definitive type of answer they wanted to hear, I’m sure. Below you will find all of the different circumstances that may change your answer from yes to no, or vice versa.
You can exclude $250,000 in profit from the sale of your main home. If you are married, you are allowed to exclude a total of $500,000.
What do I mean by main home? You need to have owned and lived in the home for a minimum of two years. These two years do not necessarily need to be consecutive as long as they are within the past five years.
You can use this “2 out of 5 year rule” to exclude your profits from the sale of your home each time you sell. For the most part, you can only use this exclusion once every two years.
Well, I said for the most part. So naturally, there are exceptions:
Exceptions to 2 of 5 Years Rule
As I said above, you normally need to live in your house for two years of the past five to exclude $250,000/$500,000 of the profit from your taxes. However, there are a few instances where you can still exclude a portion of the profit.
Location Change Due to Job
Whether you move because you’re relocating with your current company or because you are switching companies, you can exclude part of your gain.
If you are selling your house for a medical or health reason, you will have to document it. This isn’t like a letter from mom and dad that you used to get for school. You will need a letter from your physician filed away with your personal records in case of an audit. You may want to get more supporting documentation on top of the letter like scans, results, and treatment.
If your house must be sold for something unforeseen, then the above suggestion to maintain documentation stays true. The IRS says an unforeseen circumstance is “the occurrence of an event that you could not reasonably have anticipated before buying and occupying your main home.”
What are a few examples? Natural disasters, war, terrorism, employment, death, divorce, separation, or multiple births from the same pregnancy.
How is the Partial Exclusion Calculated?
So, if you meet one of the three exceptions noted above, you are eligible for a partial exclusion. How is this calculated?
You are essentially pro-rating your exclusion based on the amount of time you lived in your house. You take the amount of months you lived in the house, divide it by 24 months (two years), and multiply that by $250,000, or $500,000 if you are married.
For example, if you and your wife live in a house for 12 months but then must sell it because she had triplets, you would be entitled to exclude: (12/24)*$500,000=$250,000. Anything over a $250,000 must be counted as taxable income.
Short-Term vs. Long-Term Capital Gain
This one is quite simple. If you owned your home for one year or less, the gain should be reported as a short-term capital gain. If you owned the house for more than one year, the gain should be reported as a long-term capital gain.
What is Your Cost Basis?
Cost basis is an important factor to figure out when trying to estimate what your capital gains tax will be.
Your cost basis will be influenced by the purchase price + purchase costs (escrow, realtor) + improvements + selling costs (escrow, realtor) – accumulated depreciation (home office) = Cost basis.
Once you know your cost basis, obviously your selling price – the cost basis will give you either the gain or the loss.
Therefore, your taxable gain will be your gain – your exclusion.
Additional Resources from the IRS
All of these resources will give you more information than you even thought was available!