Liz Weston: How to reduce taxes when you sell your house
If your home’s value has skyrocketed, congratulations. If you decide to sell, beware.
Financial adviser James Guarino says some clients don’t realize profits from the sale of homes are potentially taxable until their returns are prepared – and by then they may have spent the windfall or invested the money in another house.
“They’re not happy when they find out that Uncle Sam is not only going to tax this as a capital gain, but they’re also going to be exposed at the state level,” says Guarino, a CPA and certified financial planner in Woburn, Massachusetts.
Longtime homeowners who took advantage of previous tax rules, which allowed people to carry over gains from one house to another, may be in for a particularly unpleasant surprise. These old rules could trigger taxes even if you are under the current exemption limits of $250,000 per person.
Understanding how profits from home sales are calculated — and how you can legally reduce your tax bill — could save you money and stress if you plan to take advantage of today’s house price spike.
HOW THE TAX RULES HAVE CHANGED
Until 1997, home sellers did not have to pay tax on their profits if they bought another home of equal or greater value within two years. Additionally, people 55 and older could use a one-time exclusion to avoid paying taxes on up to $125,000 of home sale profits.
The Taxpayer Relief Act of 1997 changed the rules so that instead of transferring profits to another home, homeowners could exclude up to $250,000 of profits from the sale of their home from their income. To qualify for the full exclusion, home sellers must have owned and lived in the home for at least two of the five years prior to the sale. Married couples could shelter up to $500,000.
These exclusion limits have not changed in 25 years, while home values have nearly tripled. The median selling price of a home when the law was passed was $145,800, according to the Federal Reserve Bank of St. Louis. The median was $428,700 in the first three months of this year. The median means that half of the houses are sold for less and the other half for more.
Having a taxable gain on the sale of a home used to be relatively rare outside of high-end properties and high-cost cities, but that’s no longer true, financial advisers say.
WHY YOUR TAX BASE IS IMPORTANT
Your first step in determining your gain is to identify the amount you made from the sale. This is the selling price minus selling costs, such as real estate commissions. Then calculate your tax base. This is usually the price you paid for the home, plus some closing costs and improvements. The higher the base, the lower your potentially taxable profit.
Let’s say you made $600,000 from the sale of your home. You originally bought it for $200,000 and remodeled the kitchen for $50,000. You subtract that $250,000 from the $600,000 to get $350,000 in capital gains.
If you are single, you could exclude $250,000 of the gain and pay tax on the remaining $100,000. (Long-term capital gains are normally taxed at 15% federally, although a large enough profit could push you into the top 20% of capital gains. State tax rates vary.) If you are married and can exclude up to $500,000 of the gain, you owe no tax.
However, your tax base may be lower than the purchase price if you previously deferred the gain on the sale of a home, says CPA Mary Kay Foss of Walnut Creek, Calif. Say you sold a house before 1997 and made a profit of $175,000 in the new house – the one that cost you $200,000. Your home’s initial tax base would only be $25,000. Now, if you make $600,000 from the sale, your capital gain would be $525,000, even with the $50,000 kitchen remodel.
Other factors could increase your tax base and reduce your potentially taxable earnings. If you owned a house with a deceased spouse, for example, at least half of the base of the house would be “increased” or brought to market value at the time of your partner’s death. If you live in a community property state such as California, both halves of the house benefit from this increased tax base.
HOW TO REDUCE YOUR GAINS
Another way to build your base is home improvement. To be eligible, improvements must “add to the value of your home, extend its useful life, or adapt it to new uses,” according to IRS Publication 523, Selling Your Home.
Additions of rooms, updated kitchens and new number of plumbing; repairs or maintenance, such as painting, generally do not. You also can’t count upgrades that were later ripped out or replaced.
Door-to-door sellers should carefully review Publication 523 to understand what costs may reduce their earnings and keep records — such as receipts — in case they are audited, says Susan Allen, senior tax practices and ethics manager for the American Institute of CPAs.
“Be proactive in keeping your records, because we all know that if you come back 10 years later and you’re looking for something, it’s a lot harder to find,” Allen says.
This column was provided to The Associated Press by personal finance site NerdWallet. The content is for educational and informational purposes and does not constitute investment advice. Liz Weston is a NerdWallet columnist, certified financial planner, and author of “Your Credit Score.” Email: [email protected] Twitter: @lizweston.
NerdWallet: Personal Finance Defined: The Guide to Maximizing Your Money https://bit.ly/nerdwallet-personal-finance-defined-the-guide-to-maximizing-your-money