Avoid Capital Gains Tax on the Sale of Your Home

Here's a piece courtesy of Marotta Asset Management on how to avoid capital gains on the sale of your house:

If you own a home you are likely aware of the tax benefits such as deducting your mortgage interest and property taxes. However, you may not be aware of the tax-free earnings you can take after you sell your home. Under the Taxpayers Relief Act of 1997, capital gains generated from the sale of a primary residence are tax-free. Individuals pay no taxes on profits up to $250,000. And, couples are allowed to combine their tax credit and exclude up to twice the amount from a home sale.

The income exclusion is so lucrative many homeowners have adopted a lifestyle of home improvement with the hopes of buying low, selling high and making a handsome tax-free profit every two years. A little elbow grease invested in home improvements can generate a handsome reward on the day of sale. Imagine selling your home at a significant markup and paying no taxes on that income.

Previously, profits from the sale of a home automatically triggered capital gains tax, unless that is, you plunked the profits back into another home with a bigger price tag. The only other option was a one-time exclusion of $125,000 if you were over 55. Under current tax law, there’s no need to apply your gains to the purchase of another home. Profits can be spent on a trip to Europe, or better yet, saved and invested.

Capital gains is figured by taking the sale price of the house and subtracting your closing costs, realtor fees, and cost basis (what you paid for the house plus any significant house repairs). What’s left is your profit, or capital gains. If you are filing individually, any profits up to $250,000 ($500,000 if you are a couple) are yours to keep, tax free!

Let’s consider an example. The Smiths purchased their home for $100,000. Over the years, they invest another $50,000 in renovations into the house. Once the kids leave for college, they decided to downsize. With many years of appreciation, the Smith’s home sold for $500,000. Fees and realtor’s commission aside, their profit on the house was $350,000 ($500,000-$150,000). Under the Taxpayer Relief Act, the Smiths pay no taxes on the $350,000 profit. Not bad.

As with any great offer, there is of course, the fine print at the bottom. For one, you can only claim the exclusion every two years. And to qualify, you’ll need to pass two important tests: the "ownership" and "use" tests.

The "ownership" test requires you to have owned the home for two years. To pass the "use" test, you must have lived in the home as your primary residence for two of the past five years. Your two years can be a combined total of 760 nonconsecutive days over a five-year period in which you lived in the home as your primary place of residence.

Let’s look at another example. Newlyweds, Jack and Jill live in Manhattan. After their wedding, Jack moved into Jill’s townhouse, a home Jill had owned for the previous five years. Soon after their wedding, Jack and Jill decide to sell the home. They sell the home and make a profit of $400,000.

In this example, although Jack and Jill were just married and ownership moved from individual to joint ownership, the home has not changed hands. Uncle Sam will allow them to pass the ownership test. But, to pass the "use" test, both parties must live in the house for two of the past five years. In this case, only Jill meets the criteria, so only $250,000 of the earnings can be excluded. Jack and Jill will have to pay capital gains tax on the remaining $150,000.

Waiting until the two-year anniversary to sell your home will likely be worth the wait. Homeowners who sell their home before they reach the two-years mark will find no pot of tax-free gold at the end of the rainbow. Any profits generated from the sale of a home which exceed your exclusion limit will be taxed at the long-term capital gains tax rate of either 5 or 15 percent, depending on your tax bracket.

Profits from the sale of a home owned for more than one year but less than two years will be taxed at the long-term capital gains of either 5 or 15 percent. Worse yet, homeowners buying and selling within a one year period are taxed at the ordinary income rate, anywhere from 10 to 35 percent.

There are, however, some welcome exceptions to the rules. If you are divorced and gained full ownership of your home as part of a divorce settlement, you are permitted to take the full exclusion of up to $500,000, assuming you still pass the two-year "use" test.

Members of the armed forces who are forced to relocate can take the full exemption regardless of how long they have owned their home. Homeowners forced to relocate due to health reasons, divorce, or job reassignments may take a pro-rated exclusion if they don’t meet the full two-year "ownership" and "use" tests.

If you are hoping to sell your vacation house - the one you visit for two weeks out of the year - you won’t qualify you for the exemption. However you might consider moving your official place of residence to your vacation house, live in it for two years, and then take the exclusion.

In May 2006, President Bush signed into law new tax laws extending the lower capital gains tax rates until 2010. Through 2010, sellers who turn a profit over and above the exclusion limits will pay a maximum capital gain tax of 15 percent. Sellers in the lowest two tax brackets will see their capital gains rate of 5 percent in 2006 and 2007 drop to 0 percent from 2008 through 2010. After 2010, all long-term capital gains tax will move back up to 20 and 10 percent respectively.

Of course, these considerations alone should not dictate when you sell your home but should be part of your overall financial plan.

Comments

[Lord]

California caps property tax increases at 2% on the purchase price and this limitation can amount to much more than escaping capital gains tax, which can be escaped in any event by leaving it to your heirs.

[Kurt]

I assume you can add capital improvements to your basis (as described above). Can you add property tax payments as well?

[Clayton]

Where in the tax code does it say that a spouse gaining full ownership of a house due to a divorce settlement can claim a $500,000 exclusion?

[FMF]

Clayton --

Contact Marotta if you have specific questions. Their website is listed as the top link.

[Cheryl Hanback]

I have a client whose parents bougt a house for $16,000 40 years ago. 1/2 of house to daughter when parents were separated-20 some years ago and 10 years ago daughter inherited mom's other 1/2. Dad lived in the property alone (daughter was soul owner-until he died this year. Daughter wants to sell house. She cannot live in hiouse for 2 years. Is there ANY way she can defer/avoid capital gains-it ws only her primary residence whn she ws growing up and giong to high school ages ago.

[Eduardo Elizondo]

Greetings, a little help from any of you tax wizards out there. My mother divorced my Pops gaining sole ownership of the house, shes passes the "ownership" rule, upon selling can she take the full $500,000 exclusion. Gracias amigos.

[Mary Anderson]

Does the divorce exclusion (the wife getting the total $500,000 write off)if it was a common law marriage in WA State and the couple split leaving the wife with the house through a quit claim deed??

[FMF]

Mary --

I suggest you contact the author of this piece -- Marotta Asset Management (linked above) -- to get this question answered.

[Eduardo Elizondo]

I asked a tax consultant about the paragragh above--"There are, however, some welcome exceptions to the rules. If you are divorced and gained full ownership of your home as part of a divorce settlement, you are permitted to take the full exclusion of up to $500,000, assuming you still pass the two-year "use" test."--My consutant advised me that this one false information. Can you referrence the Tax code where this information is viable?

[FMF]

Eduardo --

As I mentioned above in the comments -- contact Marotta (the author of this piece) if you have specific questions. Their website is listed as the top link.

[David Court]

I have an investment property in Queensland, of which I made my principle place of residence in April 2007, I renewed my license and vehicle registration at this address at this time and registered on the electoral role and voted there in 2007.
I have physically been in the property since early January 2008,electricity etc was placed in my name then. I am in the defence force but my posting has required me to be based back to Sydney, I am now considering selling the property due to the fact I will only be able to go there when not deployed,I had not intended claiming any deductions from 1 July 07 until 30 June 08 (financial year)on the property.
I do not want to place tenants back into the property and intend leaving most of my belongings in it, rather than rent it out and have it damaged again.
I have carried out renovations and repairs enabling me to move in
What are the implications for me (sole title holder)on CGT due to this being my principle place of residence and now selling the property and what portion of CGT could I be up for.
I have had Too many varying reports from nil to half I have consulted an accountant.
Thanks
Confused

[Fawn Pirruccello]

I own a farm type single family home in maine on 7 acres recently I was approached by the power co and they needed some of my land for a upgrade to their system their is no eminate domain where I live but they still needed the land because of the voltages involved no one would be able to live under the lines the property they needed would have been a perfect spot to build a rental property but they which I had planed on doing but now with the lines going up no one could build there anyway. so I sold them about one and 3/4 acre for 80000 dollars I had a 63,000 dollar mortgage on the whole place so in order for the mortgage co to release the property I had them pay off the mortgage and then I gave them a deed for the property they wanted and I ended up with about 17,000 how does the tax get figured on this mess

[Vernon Groston]

I see a few things a lot: people either treat their home or property in general as the only asset class in their portfolio or they forget about it all together. You have to consider these tips when you are making adjustments or are thinking about your next investment move – and I’m not even a broker lol. It’s all about taking a holistic look at your portfolio and life situation.