A home is usually the largest purchase one makes. This makes planning for the potential tax bill a must. While most people have heard of the $250,000/$500,000 exclusion from taxes that a primary residence receives, there are multiple complexities, myths, and exceptions to the rules that can determine the tax liability upon the sale of a home. We’ll tackle two examples in today’s post.
The Rule – Excluding Your Home from Capital Gains
§121 of the tax code allows individual taxpayers to exclude up to $250,000 in gains on the sale of their home, or $500,000 for married taxpayers. Taxpayers must have both owned and used the home as their primary residence for two out of the last five years ending on the date of sale. A persistent myth is that homeowners need to have used the home for the two years prior to selling. The rule, in fact, is that use of the home could have occurred in ANY two of the last five years prior to the sale date. While it rarely occurs, it is possible to count rental time of a particular home toward the two year use requirement if the home is later purchased by the renter.
Selling a Home without Recently Living in It:
Example 1 – Olivia purchases a home in 2010 for $300,000. Two years later she moves to help a family member who needs her assistance with the intent of returning. A year later, she decides to sell the home for $500,000. Even though she hasn’t lived in it for a year, she is still eligible to exclude $250,000 worth of gains since she used and owned the home for two out of the last five years.
If Olivia’s capital gains tax rate is 15%, her federal tax savings as a result of the exemption would be $30,000. In Colorado, the income tax rate is 4.63%, leading to an additional tax savings of $9,260.
Renting Out a Home and Avoiding Capital Gains Tax.
Another important exception that ties into the above example is that it doesn’t matter if Olivia let the house sit vacant or if she rented it for that year. As long as the rental period occurs after she met the two years of use rule, she could rent it for up to three years and still make use of the exclusion. She would only have to pay taxes on the depreciation she was allowed to claim during the rental period.
In the event that Olivia used the home as a rental before moving in to meet the two-year requirement, she would have a pro-rated exclusion. This “non-qualifying” rental use is based on periods starting in 2009 and later. When the rental period, or non-qualifying use period, occurs before the taxpayer uses the home as their residence, the gain gets split between the time the property was used as a main residence and any time after 2009 that it wasn’t used as a main residence.
Example – Olivia purchases a home in 2007 and uses it as a rental. In 2012, she moves in and makes it her principal residence. She lives there for 3 years before selling. She purchased the property for $300,000, and sold it for $600,000. During the rental period, she had $50,000 in depreciation.
In this case, Olivia’s “non-qualified” use is the amount of time starting in 2009 and later that the residence was a rental, or 3 years. She owns the home for a total of 8 years, making her ratio 3/8. Therefore, of the $300,000 gain, $112,500 is attributable to non-qualified use and is taxable as a capital gain. The remaining $187,500 is excluded and is tax-free. The $50,000 of depreciation is recaptured.
We’ve highlighted a few exceptions to the home exclusion, but there are many other situations and exceptions that impact the taxability of a home. With proper tax planning, taxes on the sale of residential property can be minimized or even eliminated, leaving more resources to achieve other financial goals.