Now is a good time to be a homeowner. A combination of factors—including an extended period of record-low interest rates, rising stock prices, and a relatively strong economy—have caused U.S. home values to increase significantly over the last decade. At the same time, many Americans are looking to move. The COVID-19 pandemic and rise of remote working have caused many people to evaluate where they want to live, and millions of baby boomers are getting ready to retire and possibly move to warmer climates.
If you are among the many Americans considering selling your home in this hot residential real estate market, we encourage you to think carefully about how a sale may affect your tax bill. Just as importantly, you should understand the many costs involved in selling a home—both tax-related and otherwise—so you are aware of how much cash you will take home, wherever you decide home will be.
We highlight the key tax implications of selling a home and how you can position yourself for a successful outcome.
Home is where the capital gain is.
A home is a capital asset and is therefore subject to capital gains taxes. The federal government charges short-term capital gains taxes on property held for less than one year at the individual’s regular income tax rate. But if a homeowner has owned his or her property for more than a year—which is usually the case for homeowners—long-term capital gains taxes might apply.
Under the Taxpayer Relief Act of 1997, homeowners are provided some exemptions if they have used their home as their primary residence for at least two of the past five years. Under the “two-out-of-five-year-rule,” single taxpayers pay no capital gains taxes on the first $250,000 of profit (the difference between the sale price and the buyer’s cost basis). Married couples filing their taxes jointly, meanwhile, receive a $500,000 exemption. Profits above these levels are subject to capital gains taxes, but owners can deduct the other costs related to selling a home—such as a real estate broker’s fee and other transfer fees—as well as the cost of any improvements to the property.
U.S. taxpayers can only take this primary residence exemption once every two years. For married couples filing jointly, both spouses must meet the conditions of the exemption to qualify. For example, if a husband and wife own a home together and want to sell it, they both need to have lived in the home for two of the past five years to qualify for the exemption. This condition is designed to prevent abuse of the exemption among couples who may own multiple properties.
Can I claim an exemption? It depends.
Broadly speaking, U.S. tax laws are favorable to homeowners, but they only apply under certain conditions. For example, primary residence laws don’t apply to vacation homes or business properties.
Also, different conditions apply to arm’s length transactions versus selling to a family member. (In an arm’s length sale, the buyer and seller have no prior relationship and each act in their own financial interest.) A sale to a family member will be covered by estate tax laws, which involve specific regulations for both buyers and sellers. For example, some sellers may be interested in selling a home to a family member at below market value. While this is perfectly acceptable, keep in mind that any difference between the sale price and the true market value of the home will be considered a gift to the buyer and will apply to the IRS’s annual and lifetime limits on giving for the seller.
As a hypothetical example, let’s say a mother wants to sell her $500,000 home to her daughter for $300,000. The difference between the sale price and the true market value—in this case $200,000—will be considered a gift to the daughter and count towards the mother’s annual and lifetime limits on non-taxable giving. Because $200,000 is more than the IRS’s annual limit on non-taxable giving—currently $16,000—the mother will need to report the gift. The gift will count against her lifetime non-taxable giving limit for single individuals, which is currently $12,060,000.
Since there is higher potential for fraud in non-arm’s length sales, regulators tend to scrutinize these transactions more closely. To avoid complications, non-arm’s length buyers and sellers should keep detailed documentation of the sale. Homeowners also should consult with a tax advisor or CPA for guidance on how to best conduct a sale among family members.
Augusta Rule: What does the Masters golf tournament have to do with real estate taxes?
It is common (and lucrative) for homeowners in Augusta, Georgia to rent out their homes during the annual Masters golf tournament. And because of a wrinkle in the tax code, this rental income can be income-tax free.
The so-called “Augusta Rule” (Section 280A of the IRS code) allows homeowners to rent their property for 14 or fewer days per year without having to report the rental income to the IRS as long as the home is not a full-time rental property. This rule got its name from the fact that residents of Augusta, Georgia lobbied strongly for its passage in Congress, but it applies regardless of where the property is located.
Before you sell, what will you take home?
Selling a home is a momentous decision and a major part of many people’s long-term financial planning. Like any decision related to investing, it is crucial to understand the after-tax cash proceeds of a sale before you act.
For many Americans, the standard $500,000 tax exemption will be sufficient. But for others—particularly those living in high-growth markets like California or Austin, Texas or who have lived in their homes for several decades—your gains may exceed the exemption. And federal taxes aren’t the only factor to consider. Remember that there may be local and state taxes on real estate sales depending on where you live as well as various fees involved in a sale, such as brokerage fees and closing costs.
If you are considering selling your home, contact your Leelyn Smith advisor to learn more about how much cash you can expect to take home—and how the decision factors into your overall financial plan.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.