It has been a wild ride for buyers and sellers in the US housing market over the past year. The year-over-year growth rate for home prices reached 20.1% in April 2022— the highest level in more than two decades. But rates fell after that, dropping to just 8.6% by November.
What does that mean? Homeowners may be grappling with gains and losses on sales, and that can translate to confusion at tax time. Here's what you need to know.
Not All Gain Is Taxable
Some taxpayers believe that any profit on the sale of a home is taxable—but that's not true. There is an exclusion on capital gains up to $250,000, or $500,000 for married taxpayers, on the gain from the sale of your main home. That exclusion is available to all qualifying taxpayers—no matter your age—who have owned and lived in their home for two of the five years before the sale.
And, there’s no rule that says what you have to do with the proceeds. Despite a popular rumor, you don’t have to invest in another home or investment to qualify for the exclusion. You could buy a new home, pocket the cash, or gamble it away at the Golden Nugget—the result is the same.
Main Home
The exclusion applies to the sale of your main home. If you have more than one home, your main home is typically the one you live in most of the time. And, your house doesn't have to be a single-family home—a condominium, a cooperative apartment, a mobile home, or a houseboat could all qualify as your main home.
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Qualifying Criteria
You can meet the ownership and use tests during different periods—like year one and year three—so long as you must meet both tests during the five years.
The capital gains exclusion applies to your principal residence, and while you may only have one of those at a time, you may have more than one during your lifetime. There is no longer a one-time exemption—that was the old rule, but it changed in 1997. That means today you can use the exclusion multiple times so long as you meet the criteria each time.
Reporting
An exclusion typically means you don't have to include the amount in your income. However, if you receive an informational income-reporting document, like Form 1099-S, you must report the sale even if the gain is excludable. Additionally, you must report the sale if you can't exclude all of your capital gains from income (more on that in a bit).
If it's a reportable sale, you'll file Schedule D and Form 8949 with your Form 1040.
Figuring Your Gain
Your starting point for figuring your capital gain is your basis. Basis is the price you originally paid for the house plus any significant improvements. For example, if you buy a house for $200,000, that's your cost basis. If you make a capital improvement—a change that adds permanent value to your home, like an addition—it will increase your basis. If you make a change like that, keep good records.
Let's assume you added a mother-in-law's suite at a cost of $60,000. Your basis is now $260,000, or $200,000 (original purchase price) plus $60,000 (addition).
When you sell your home, your gain is the difference between the selling price and your basis. So, continuing the example, 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, let's account for the capital gains exclusion. The exclusion is up to $250,000 for single taxpayers or $500,000 for married taxpayers. That means if you are married, you will subtract $500,000 from your gain—in our example, the gain was $440,000. Since the exclusion is more than your gain, there is no capital gains tax on the sale.
If you were single, however, you'd subtract $250,000 from your gain—again, the gain in our example is $440,000. In that case, your gain is $190,000 more than your exclusion, so capital gains tax would apply.
Capital Gains Tax
The difference between your selling price and your basis is simply your gain, not the tax owed.
If you owned your home for one year or less and then sold it, your capital gain is short-term, and you'll be taxed at your ordinary income tax rate.
However, if you have owned your home for over a year, your capital gain above the exclusion is long-term. For 2022, the long-term capital gains rates for most capital assets are 0%, 15%, or 20%, depending on your taxable income.
Losses
If your basis is more than the selling price, you have a loss.
Let’s assume, for example, that your basis was $260,000 and you sold your home for $100,000, leaving you with a $160,000 loss. While it’s a hit to your wallet, there is no tax impact—you can't claim a loss on the sale of a personal residence.
Suspension Of Time
The exclusion rules are very specific, including the ownership and residency rules. However, if you or your spouse are on qualified official extended duty in the Uniformed Services, Foreign Service, or intelligence community, you can suspend the five-year test period for up to 10 years. You're considered to be on qualified official extended duty if, for more than 90 days or an indefinite period, you are at a duty station at least 50 miles from your main home or residing under orders in government housing.
Exceptions
Since this is tax law, there are a few more exceptions that may apply. For example, you would have no reportable gain or loss if you transferred your home, or share of a jointly owned home, to a spouse or ex-spouse as part of a divorce settlement. This exception does not apply if your spouse or ex-spouse is a nonresident alien.
If you become physically or mentally unable to care for yourself, and you use the residence as your principal residence for at least 12 months of the 5 years before the sale or exchange, any time you spent living in a care facility, like a nursing home, counts toward your residence requirement. That's true so long as the facility has a license from a state or other political entity to care for you.
Other exceptions may affect your gain, including those involving a deceased taxpayer, vacant land, or a destroyed or condemned home.
If you have a situation that doesn’t appear to fit in neatly with the rules, check IRS Publication 523 or consult with your tax professional for more information.
Home Sales In 2023
So what about this year? Experts are mixed on what the housing market will look like for the remainder of 2023. Most agree that fewer homes will be on the market, but housing prices aren't expected to dip much. Dennis Shirshikov, a strategist at Awning.com and a professor of economics and finance at City University of New York, has suggested that "home prices won't drop in 2023."
That could mean that many homeowners will still turn a profit. And, assuming no changes from Congress, the same capital gains rules will apply in 2023 as were applicable in 2022.
If you're thinking about selling this year, start planning now. While any gain recognized in 2023 won’t be reportable or taxable until 2024, figuring out your basis and adjustments now, including scrounging up those receipts, will save you a headache next tax season.
