The US housing market has been a wild ride for buyers and sellers over the last year. In April 2022, the year-over-year rise rate for home prices hit 20.1%, the highest level in more than two decades. However, rates declined following that, falling to 8.6% by November, according to Forbes.
What does this imply? Homeowners may be dealing with sales gains and losses, which can lead to tax uncertainty. Here’s what you should know.
Several people believe that any profit from the sale of a home is taxable; however, this is not the case. The gain from the sale of your primary residence is exempt from capital gains tax up to $250,000, or $500,000 for married taxpayers. This exclusion is offered to all qualified taxpayers, whatever of age, who owned and resided in their house for two of the five years preceding the sale.
Furthermore, there is no rule dictating what you must do with the money. Contrary to common belief, you are not required to invest in another property or investment to qualify for the exclusion. The outcome is the same whether you purchase a new house, save the money, or gamble it away at the Golden Nugget.
The exclusion applies to the sale of your primary residence. If you have more than one home, your primary residence is usually the one in which you spend the majority of your time. Yet your primary residence does not have to be a single-family home; it may be a condominium, a cooperative apartment, a mobile home, or a houseboat.
You can meet the ownership and use tests at various times, such as year one and year three, as long as you meet both over the five-year period.
The capital gains exclusion applies to your principal house, and while you can only have one at a time, you can have multiples throughout your lifetime. There is no longer a one-time exemption—this was the old norm before 1997. That is, you can now use the exclusion several times as long as you meet the conditions each time.
An exclusion usually indicates that you are not required to include the amount in your income. If you get an informational income-reporting document, such as Form 1099-S, you must report the transaction regardless of whether the gain is excludable. You must also record the sale if you cannot deduct all of your capital gains from your income (more on that in a bit).
If the sale is reportable, you must file Schedule D and Form 8949 together with your Form 1040.
Your basis is the beginning point for calculating your capital gain. The basis is the initial purchase price plus any significant improvements. For example, if you pay $200,000 for a house, that is your cost basis. If you make a capital improvement—a alteration that adds permanent worth to your house, such as an addition—your base will rise. Keep detailed records if you make such a change.
Let’s say you spent $60,000 to add a mother-in-law suite. Your base is now $260,000, or $200,000 plus $60,000 (original purchase price) (addition).
When you sell your house, the difference between the selling price and your basis is your gain. Hence, if you sold your house for $700,000 and your basis was $260,000, your gain is $440,000, or $700,000 minus $260,000.
Now consider the capital gains exclusion. The exclusion is worth up to $250,000 for single filers and $500,000 for married filers. If you are married, you will deduct $500,000 from your gain, which in our example was $440,000. There is no capital gains tax on the sale because the deduction exceeds your gain.
If you were single, you would deduct $250,000 from your gain—in our case, the gain is $440,000. In that situation, your gain exceeds your exclusion by $190,000, therefore capital gains tax would apply.
The difference between your selling price and your basis is your gain, not your tax liability.
If you owned your house for one year or less before selling it, your capital gain is considered short-term and will be taxed at your ordinary income tax rate.
If you have owned your house for more than a year, however, your capital gain over the exclusion is long-term. Long-term capital gains rates on most capital assets are 0%, 15%, or 20% in 2022, depending on taxable income.
If your base exceeds the selling price, you will incur a loss.
Assume your basis was $260,000 and you sold your house for $100,000, leaving you with a $160,000 loss. While it is a financial setback, there is no tax ramification—you cannot claim a loss on the sale of a personal residence.
The exclusion regulations are extremely specific, including ownership and residency requirements. If you or your spouse is on qualified official extended duty in the Uniformed Services, Foreign Service, or intelligence community, the five-year test period can be suspended for up to ten years. You are deemed to be on qualified official extended duty if you are stationed at a duty station at least 50 miles away from your primary residence for more than 90 days or indefinitely.
Because this is tax legislation, there may be a few more exclusions. For example, if you transferred your home, or a stake of a jointly held home, to a spouse or ex-spouse as part of a divorce settlement, you would have no reportable gain or loss. If your spouse or ex-spouse is a nonresident alien, this exception does not apply.
If you become physically or mentally incapable of caring for yourself and use the residence as your primary residence for at least 12 months in the five years preceding the sale or exchange, any time spent in a care facility, such as a nursing home, counts against your residence requirement. It is true as long as the facility has a state or other political entity license to care for you.
Additional exclusions, such as those involving a deceased taxpayer, abandoned land, or a destroyed or condemned home, may have an impact on your gain.
How about this year? Analysts are divided on how the home market will do throughout the rest of 2023. Most people agree that there will be fewer homes on the market, but housing prices aren’t projected to fall significantly. Dennis Shirshikov, an Awning.com strategist and City University of New York professor of economics and finance, has predicted that “home prices will not fall in 2023.”
This could imply that many homeowners will still profit. Furthermore, assuming no changes from Congress, the same capital gains regulations will apply in 2023 as they did in 2022.
Start planning now if you intend to sell this year. While any gain recognized in 2023 will not be reportable or taxable until 2024, determining your basis and adjustments now, including gathering receipts, can save you a hassle next tax season.