Selling Residences: Income Tax Treatment
Introduction. Generally, under the Internal Revenue Code, you will be forced to pay taxes on any transaction that involves real estate and produces a gain at the time of the sale. However, if you sell your house, the Internal Revenue Code gives taxpayers a special tax treatment. Certain rules apply, and if you are contemplating such a sale, it is absolutely critical to understand these rules before you sell.
Some General Considerations. Under the current Internal Revenue Code provisions, you can completely exclude up to $250,000 worth of gain on the sale of your house [up to $500,000 if you are filing jointly.] In addition, any gain you might be required to report will be considered a long-term capital gain provided you held the property for more than one year, and will be taxed at the maximum capital gains tax rate of 20%, with some applicable tax rates as low as 10%. All of this tax treatment is favorable and is significantly lower than being forced to pay taxes at the ordinary tax rate on any such gains.
Preliminary Issue: Which is Your Home? The IRS considers the provisions of the Tax Code that exempt any gain to be applicable to the sale of your main home. That is, if you own two houses and you live in one 1/3 of the year and the other 2/3 of the year, the main home is the one you live in 2/3 of the year. A main home can be a house, a mobile home, a houseboat, a townhouse, a condominium, a cooperative or possibly other type of house, provided you can justify to the IRS that such a structure is considered your main house.
You should be careful, because the IRS usually does not give private rulings just for your house sale, and as such if your determination of your main house is wrong, you may end up with substantial interest and penalties, if audited.
What happens to the other home, if you sell it? If you sell a house that is not considered your main home, you will be taxed in the year of the sale. Many rules apply to such a sale, and you should consult a tax specialist for advice before such a sale if possible. Such advice may enable you to have the proceeds from the sale of the other house (not your main home) to receive at least capital gains treatment, which may be better than ordinary income tax treatment.
How is My Main Home Sale Taxed? You must determine whether you have made a gain or loss on the sale of the property for IRS purposes. Sales of a main home resulting in a loss are not deductible in this year's return. To determine if you have a gain, you must take the selling price and subtract from it the selling expenses and the home's basis.
Once you know the selling price and the selling expenses and the adjusted basis, you can calculate a gain or loss. Use this formula:
Selling Price - Selling Expenses - Adjusted Basis = Gain [or Loss]
If you have a gain, you can exclude the income you received as your gain from your tax return for the current year up to the allowable limits. If you file as a single taxpayer, you can exclude up to $250,000 of the gain from your return, and if you file a joint return, you can exclude up to $500,000 of gain from your return.
Selling expenses may include:
- Advertising Fees;
- Legal Fees; and
- Loan charges, known as "points."
Basis. You cannot know whether you sold your home for a gain or a loss or broke even, unless you know what your basis in the home is. You can think of the basis as the cost of your home to you. However, this is a general rule and your basis for income tax purposes may have a few other components other than the price you paid for your home. For example, if you built your home, your basis is the cost of building it. If you inherited your home, your basis is the FMV [fair market value] on the date you inherited it.
Also, while you owned your home, you may have made changes to it. Some of these changes may have increased or decreased the basis. Calculating the effect of these changes is called an adjusted basis. The Internal Revenue Code in each year will specify which changes that were made to a home can be utilized to adjust the basis. The Internal Revenue Code will also determine whether the changes will require you to adjust the basis up or down.
What About If I Traded Properties - Is this a Gain [Loss]? Yes, you can treat the trade as a sale and a purchase, as long as it is trading an old home for a new home. As an example: Assume you had an old home with an adjusted basis of $62,000. You traded it for a new home that has a purchase price or FMV of $92,000. You determined that in the trade the old home would have a FMV of $85,000. You would take the Selling Price (FMV) [$85,000] and subtract from it the Selling Costs [here none] and subtract the adjusted basis [$62,000]. The gain is $23,000, and under today's tax rules, you can exclude $23,000 of gain from your tax return.
Other Transfers. Other transfers, such as foreclosures or abandonments, may have the same or different treatment depending upon the tax provisions in effect at the time. Transfers to spouses may not have any tax consequences. If you are involved in a situation that involves more than just a sale of your residence, you may wish to consult with an experienced tax practitioner.