This is a subject that you won’t due often, but most likely you will sell a home in your lifetime. We need to write this, because year after year we get calls about this and/or the taxpayers are misinformed about the taxability of selling property. The most common errors are 1 – the belief that those over 55 gets a 1 time $125,000 exclusion, if another house was bought,* and 2 (which I’ve caught some relators on this) – you sold your rental unit, but bought a single family house, so no taxes are due. Most of the time, the damage is done when it gets time to do your taxes. This article will focus on residential property, so knowing the rules will save you a lot of anguish. IRS Publications 523 & 527 are very clear about the taxability on homes. I will break them out by category. In each case, a form 1099-S will be sent to IRS at closing.
If its your personal residence, most likely no. Gains are determined by taking the selling price less commissions and closing costs against the cost of your home plus improvements. The current law gives you a tax break if your home is your primary residence for at least two (2) years in a 5 year period. Each taxpayer is allowed a $250,000 exclusion, so a married couple can make a $500,000 profit selling their home before taxable gains starts. (Example: The Smith’s (married) purchased a house that was their residence in 2014 for $300,000 and added $30,000 in renovations. The cost is $330,000. They sold it in 2017 for $650,000. Their gain on the home was $320,000 because each spouse gets a $250K exemption of $500K, there is no tax. If the situation was that Smith was a single person, then Smith’s taxable gain is $70K ($320K less $250K single exclusion). Note – the residence must be owned for 2 years, but there are exceptions such as disability, divorce, widowed, house destroyed and military duty are most common ones.
Vacation or Second Home
If is a second or vacation home, the exclusion is disallowed. Therefore, there will be a tax if the proceeds are more than your cost basis. The maximum is 20% depending on your bracket for the federal and 5% for Mass, if you owned it more than 1 year. Estimated tax for Smith (from previous example) – single or married – in the gain listed above could be as high as $64,000 federal and $16,000 Mass.
In this instance, it does get tricky. After the cost basis is established, the IRS treats this as a business asset. IRS law states that the home plus improvements (appliances also) are to be written off over several years as a depreciation deduction. This gives you a short term benefit, but it also reduces your cost basis. The tax is now calculated at up to 20% for the property and up to 25% for the total depreciation written off. It is still a straight 5% for Mass.
Take the above situation for Smith single that it was a rental. Cost basis is $330,000 in Jan. 1, 2014. $330K rental real estate gets written off over 27.5 years (IRS pub 946), so it is $12,000 per year. It was sold July 1, 2017 for $650K. The gain is as follows: $650K less $320K, plus depreciation written off for 2.5 years at $12K per year or another $30K. Total gain is $320K long term capital gain plus $30K depreciation taken.
Smith would pay $64,000 LT Gain tax plus $7500 tax on depreciation as well as $17,500 Mass Gain tax (Tax is 5% on both $320K gain and $30K depreciation).
Shared Residence – Rental
In the case of a multi-family home where one apartment is your residence and the other is rented, it is treated as two separate transactions. (Single homes where rooms are rented to Exchange students or by AirBnB also fall into this category). Your residence is treated as a personal residence, so any gain can be offset by the $250K exclusion per person. The rental portion of the home is viewed as rental income and is subject to capital gain tax plus depreciation. Let’s assume that this 2-family home was half residence and half rental. Then Smith’s situation would look like this:
Residence Portion Rental Portion
Bought Jan 1, 2014 – $300K $150,000 $150,000
Improvements – $30K $15,000 $15,000
Cost Basis – $330K $165,000 $165,000
Sold July 1, 2017 – $650K $325,000 $325,000
Depreciation taken – only 1/2 of $30,000 to rental unit None/0 $15,000
Gain of property $160,000 $160,000 plus $15,000 depreciation taken or $175,000
Residence Exclusion $250,000 None/0
Tax Due None. If $160K gain is less than the $250K exclusion, so no tax. $32,000 capital gain tax on $160,000 plus $3750 tax on depreciation taken.
Before you sell, call your tax advisor to find out what your situation may be. They can calculate an estimated tax and possibly delay paying the tax. There are ways that taxes can be delayed such as a 1031 exchange where the proceeds are put into an escrow account until another real estate investment is bought. That is very complex and involves an attorney before the sale is closed. Again, consult your tax advisor before you sell your property, “An ounce of prevention is worth a pound of cure.”
*That was the old rule for tax exclusion on primary residences. That was changed under the Clinton administration, adjusted under Bush and again under Obama where it still exists. The new tax law under Trump did not affect this.
* In 2008, the Bush administration passed an incentive for first time home buyers. Those who bought then received a first-time home buyers credit of $7,500. This was to be repaid over the next 15 years at a rate of $500 per year with the balance die if you sold your home.