It feels like everyone sold their homes this year. And why not? The property market is up big time. Zillow Research found that the US home market was up 19.5% in 2021 and they are further projecting that 2022 home prices will be up another 11%.
For many, getting top dollar for their homes has been a good feeling. But many taxpayers could experience a big tax surprise in April when they file their return – a capital gain triggered by the increased price.
It’s essential for taxpayers to understand the basic rules surrounding the sale of a primary residence so they can be prepared at tax filing time.
What Is the Tax Treatment When You Sell Your Home?
The first thing to consider is what is the actual tax rule when selling your home or what is Section 121 of the tax code.
“Section 121 addresses whether or not the gain from the sale of your primary residence is taxable. For taxpayers filing married jointly, the exclusion of taxable gain is up to $500,000; for everyone else, it’s $250,000,” says Lorilyn Wilson, CPA & CEO of Lookahead LLC and DueNorth PDX.
Further, Section 121 focuses on two main aspects: ownership and use.
“To qualify for this exclusion, the taxpayer must have occupied the home for two of the past five years (the two years do not have to be subsequent) and must not have claimed this exclusion in the prior two years,” says Wilson.
The use test is often where there is some confusion. The taxpayer must have used the property as their primary residence for 24 months or two years during a 60-month period.
For example, taxpayer could have purchased their home in February 2015, and lived in it as their primary residence until February 2016 when their company asked them to take an assignment. Taxpayer retains the home and moves back into the home as a primary residence in June of 2017. In June of 2018, they put the home up for sale. That would qualify for the exemption.
Basis, Basis and Basis!
But once taxpayers determine they meet the parameters of Section 121, they must determine whether the exemption covers the entire gain. It’s not always so simple.
“Where a lot of confusion occurs among taxpayers is calculating the gain – most assume it’s the difference between how much you owe on the house, and how much you sold it for,” says Wilson. “In fact, the basis of the home is what the gain is calculated from, not the loan.”
Taxpayers need to understand how basis is calculated.
“The basis is the original purchase price, plus closing costs (realtor fees, origination fees, title insurance, etc.) which can be found on your purchase closing statement,” explains Wilson.
This amount can be substantial. It is becoming more common for sellers to stage their homes or do improvements prior to selling. Further, realtors often charge 5% to 6% in fees. All of these items can be added to basis.
But that isn’t the only thing that calculates basis. Taxpayers must be sure not to forget improvements.
“Additionally – any improvements made to the home increase your basis such as remodeled bathrooms, a new kitchen, replacing a roof or new floors,” says Wilson.
Wilson gives a good example on how improvements can help mitigate any taxable gains. “Let’s say married taxpayers bought their primary residence for $200,000, made $100,000 in improvements, then sold 8 years later for $750,000. That would result in a $450,000 non-taxable gain since it’s under the $500,000 exclusion threshold,” she says.
The IRS defines an improvement as anything that permanently attaches to or improves the life of the property. If you aren’t clear if something is an improvement, you should ask your tax professional to clarify.
How To Lower Your Capital Gain
With just a few days left in the year, there aren’t many opportunities to help mitigate this taxwise. But there is one that taxpayers should consider, especially since a sale of a home is taxed at capital gain rates.
“If you have any capital losses in the year you’re selling your home, these losses can reduce some or all of the taxable gain from the sale of your home,” says Wilson. “Capital losses can result from selling real estate, stocks, or even businesses at a price lower than what you paid for them.”
For most taxpayers, these losses would likely be generated from their investment portfolio. Further, you might have carryforward losses buried in your tax return. It’s important to talk to both your tax professional and your financial advisor.
Wilson explains how they work. “If you have any capital losses from prior years that you weren’t able to offset against capital gains, those losses carry forward each year indefinitely until they can be utilized against capital gains.”
As we approach yearend, organization is key for taxpayers who will be reporting a sale of a primary residence in 2021. The best approach is to sit down with pen and paper and map out basis, costs and improvements. By being organized, taxpayers can determine if they will have an associated tax liability in April. If recognized prior to year-end, there is still the chance of finding some losses to mitigate any potential gains.