Sale of a Principal Residence: Tax Concerns, Gain Exclusions and How an Accountant can Help
Buying or selling a home is a major transaction – likely the most impactful that families will ever engage in. And, of course, major transactions come with major tax ramifications. It’s important for home sellers to be aware of and follow any tax rules, as there could be thousands at stake.
The gain exclusion rule is likely the most notable tax rule for home sellers to follow. When selling a principal residence, most people are eligible for a large tax exclusion. There are exceptions, though, so it’s critical for home sellers to know how to calculate their gains, what factors into the home’s basis, and how to verify ownership.
What is a Principal Residence? The Ownership Test
Only principal residences are eligible for gain exclusions. Second (and third, and so on) homes are disqualified from gain exclusions, but rental properties are considered business assets and are therefore eligible for gain-related tax deferments or for cost-related tax deductions.
For the purposes of this discussion, though, we’ll stick with the tax rules related to the sale of a primary residence. To determine whether a residence qualifies, the ownership test is used.
To verify that, the following must be true:
- The home seller must have owned the home for at least two years in the five years prior to the date of sale.
- The home seller must have used the residence as their principal home for at least two years in the five years prior to the date of sale.
- The gain of sale exclusion was not used during the sale of another home in the two years prior to the date of sale.
For married couples, the ownership requirement is met if either spouse qualifies. The use and gain of sale requirement, though, must be met by both. An important note: The two-year ownership and use period does not have to be consecutive and it may be tested at any time during the five years prior to sale. Also, temporary absences (like those related to vacations) are not counted against ownership or use rules, even if the property was rented out during the same time.
One last thing – if a married couple does not meet the requirements for a joint ($500,000) exclusion, they may exclude the portion of the gain that would be eligible if both spouses were single during the ownership and use period.
A Few More Ownership and Use Rules
Ownership and use can be unclear in a few circumstances. There are special rules governing these circumstances, and they include:
- In the event that a spouse dies – If a married couple would qualify for the joint gain exclusion (up to $500,000) and one spouse dies before the home is sold, the surviving spouse may take the joint exclusion if the home is sold within two years following the date of death.
- In the event of a divorce – Any spouse who owned the home prior to the divorce (which could be both spouses) is considered to be the principal owner following divorce and for the purposes of the ownership and use test.
- When a home is inherited – An inherited home that’s sold doesn’t qualify for the exclusion gain unless the beneficiary can pass the ownership and use test for the home.
Gain and Partial Gain Exclusions – How the Sale of a Principal Residence is Taxed
When a taxpayer (filing single) sells their principal residence, they may exclude up to $250,000 from the gain of the sale. Married couples (filing jointly) may exclude up to $500,000 if their home qualifies as a principal residence.
If a taxpayer (or tax paying couple) doesn’t meet the requirements for a full gain of exclusion, they may be eligible for a partial exclusion if one of the following are true:
- A qualified individual went through a change of employment.
- A qualified individual needed to move for health-related reasons or to care for a family member.
- An unforeseen circumstance or life event necessitated a home sale.
To calculate a partial exclusion, home sellers first determine what period of time they qualified for an exclusion in the previous five years from date of sale (in days or months). That number is then divided by 730 (if using days) or 24 (if using months). Finally, that number is multiplied by 250,000 to determine the amount of partial exclusion. If calculating the exclusion gain for a couple, repeat those steps for the second spouse and add the two results together.
How a Tax Accountant Can Help Their Clients Maximize the Return on a Home Sale
Families are heavily invested into their homes, so they need to pull out every dollar possible when selling. Here’s how a trusted tax expert can assist with that:
- Help determine exclusion limits – If your home sale isn’t eligible for the full exclusion, a partial exclusion may still be available. An accountant can calculate where the exclusion limit is and ensure their clients deduct as much as possible.
- Calculate the projected gain or loss on a sale – How much money you gain (or lose) on the sale has an obvious impact on taxes. However, there are many factors to consider that may impact the amount realized and final gain or loss. For example, most home selling fees (appraisal, closing, escrow, agent’s commission) may be deducted from the selling price to determine realized gain.
When assessing final gain or loss, the home’s basis must be subtracted from the realized gain. The basis includes the cost of qualified home improvements (kitchen and bathroom renovations, for example) and the cost of home construction.
Determining a home’s basis can be complicated, but an accountant can calculate it for their clients and provide a clear idea of how it will offset taxes.
- Determine whether other tax rules apply to the sale – If the sale involves a home used for business or rental purposes, any losses may be deductible. Further, taxes on any gains may be deferrable. A reputable accountant can clarify.
- Assess taxes if the gain exclusion doesn’t apply – If a home sale doesn’t qualify for a gain exclusion, the taxable portion of the sale may be subjected to capital gains taxes. An accountant can help assess those.
The Sale of a Principal Residence Can Be Confusing from a Tax Perspective, but an Expert Accountant Can Help
Large transactions come with large tax ramifications, and few transactions are as large as selling a home. There’s a lot to consider, including how to leverage the gain exclusion and how to maximize the home’s basis prior to sale.
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