When selling a principal residence, understanding the tax implications is crucial. Fortunately, the IRS provides a significant exclusion that can provide relief, softening or even eliminating the tax impact of the sale. Homeowners can exclude up to $250,000 of the gain ($500,000 for married couples filing jointly) from their income. This exclusion, set in 1997, has yet to be adjusted for inflation but still offers substantial benefits. With rising home prices, more homeowners are finding themselves in taxable territory. According to the Bureau of Labor Statistics, if adjusted for inflation, the exclusion for couples would be approximately $981,558 today.
Taxable Gains in Recent Home Sales
A recent Wall Street Journal article reported that about 8% of recent home sales have likely generated taxable gains. This percentage varies by region, with California leading at 28.8% of home sales, resulting in taxable gains in the fourth quarter of 2023. Other high-impact areas include Hawaii, Washington, D.C., Massachusetts, and Washington state, each exceeding 15% in gains above the exclusion amount.
Eligibility for Full Exclusion
To qualify for the full exclusion, the following criteria must be met:
- Ownership and Use Tests: You must have owned and lived in the home as your principal residence for at least two of the last five years.
- Married Couples: The $500,000 exclusion is available if:
- Either spouse meets the two-year ownership test.
- Both spouses meet the two-year use test.
- Neither spouse has claimed the exclusion in the past two years.
- Single Filers: If only one spouse qualifies, the other may still claim up to $250,000.
Partial Exclusion for Special Circumstances
If the two-year ownership and use tests are not met, there might still be eligibility for a partial exclusion if the sale is due to:
- A change in employment location.
- Health issues.
- Unforeseen circumstances such as:
- Multiple births from a single pregnancy.
- Job loss.
- Inability to meet mortgage payments.
- Serious illness or injury (general health improvement does not qualify)
For some homeowners, a partial exclusion might cover the entire gain, effectively serving the same purpose as the full exclusion.
Importance of Good Recordkeeping
Accurate and thorough recordkeeping is more than just a suggestion. It’s a powerful tool that puts you in control of your tax situation. It’s essential to:
- Calculate Adjusted Basis: Keep records of the purchase price and significant improvements such as kitchen upgrades, a new roof, or major renovations. These types of expenses can increase the adjusted basis of your home, reducing the taxable gain when you sell. Routine repairs, on the other hand, do not count towards the adjusted basis.
- Support Tax Claims: Maintain records of home use, especially if planning to stay long-term, have invested in significant renovations, or have claimed depreciation deductions for home office or rental use.
- Ensure Compliance: Proper documentation will help accurately calculate capital gains and determine eligibility for exclusions.
For more detailed information on allowable expenses and other relevant details, refer to IRS Publication 523.
Next Steps for Homeowners
- Confirm Eligibility: Verify that the ownership and use tests are met.
- Estimate Potential Gain: Calculate the potential capital gain from the sale of the home.
Consulting a tax professional is not just a recommendation; it’s a crucial step to provide you with the confidence and assurance you need. Seek personalized advice from a tax advisor to ensure maximum available tax benefits and compliance with IRS regulations. These steps allow homeowners to make informed decisions about selling their homes while minimizing any potential tax impact.
If you are a Legacy client and have questions, please do not hesitate to contact your Legacy advisor. If you are not a Legacy client and are interested in learning more about our approach to personalized wealth management, please contact us at 920.967.5020 or connect@lptrust.com.
This newsletter is provided for informational purposes only.
It is not intended as legal, accounting, or financial planning advice.
