You likely committed to homeownership because you knew you’d live in the house for two to three years; the locale was affordable, and, overall, a wise choice for a long-term home commitment. Plus, it had potential resale value. And, by continuously gauging the local real estate markets, you learned that your home was a good candidate to buy with renting in mind.
Regardless of the reason for your property purchase, the home's ultimate sale will have tax implications. Buying a home ignorant of an estimate on these future payments can be a costly mistake. When purchasing a home, choose real estate professionals who will not only work on your behalf to find the perfect property and execute a great deal, but who will take the time to explain tax implications and estimate the finances involved with a future sale.
Here’s a look at some of the scenarios you could experience after your home sale.
Tax Implications for Homeowners Selling a Primary Residence
For most Americans, selling a home for profit is a good thing. The government agrees and fosters the earnings by offering the home sale exclusion, also known as the primary residence exclusion when filing taxes after selling your primary residence.
Joint tax filers can exclude up to $500,000 in capital gains with this benefit. Single filers exclude up to $250,000. Beyond these amounts, your profits will be counted as capital gains income and taxed. Keep reading for more information about capital gains.
Here’s the bad news: there are restrictions on these exclusions. But, there’s also good news; military members have their own set of stipulations to offset residency rules.
- The house was your primary residence for a minimum of two of the preceding five years.
- You were the owner for a minimum of two of the preceding five years.
- No other home has used the exclusion within two years before the sale.
These are collectively known as the “2 of 5 years rule” or the use test. It serves to solidify whether or not you’ve lived in the home as a permanent residence.
For military members:
Suspension of time allows for the “2 of 5” year rule to be suspended if a PCS move was ordered for more than 50 miles away from the house. This suspension is in effect for no more than ten years and has a look-back period of 15 years. The homeowner cannot suspend more than one property at a time.
As retirement approaches, sort out with a tax professional if there are tax consequences if you decide to sell your home. Suspension of time is a complicated and unclear law when it applies to years near retirement. Consider this analysis part of your transition procedures.
Interested in real estate investment? Start Your Retirement Back Up Plan.
How Capital Gains Taxes Are Calculated
Here's a refresher on what capital gains are. In the simplest terms, when you buy a house and earn more than $250,000 (for singles) or $500,000 (joint filing) on the sale, you’ve earned capital gains. The federal government taxes a portion of these gains on this income source.
For more detailed information about military and exemptions, read The Effect of Capital Gains Tax Exclusions on Military Home Sellers.
The amount of tax owed is determined by how long the property was owned before selling. The IRS determines different capital gains tax rates for long and short-term asset ownership every year.
Here’s what the IRS says for 2021:
The tax rate on most net capital gain is no higher than 15% for most individuals. Some or all net capital gain may be taxed at 0% if your taxable income is less than or equal to:
- $40,400 for a single
- $80,800 for married filing jointly or qualifying widow(er).
A capital gain rate of 15% applies if your taxable income is:
- More than $40,400 but less than or equal to $445,850 for a single
- More than $80,800 but less than or equal to $501,600 for married filing jointly or qualifying widow(er)
- More than $54,100 but less than or equal to $473,750 for head of household
- More than $40,400 but less than or equal to $250,800 for married filing separately
However, a net capital gain tax rate of 20% applies to the extent that your taxable income exceeds the thresholds set for the 15% capital gain rate.
There are a few other exceptions where capital gains may be taxed at rates greater than 20%:
- The taxable part of a gain from selling Section 1202 qualified small business stock is taxed at a maximum 28% rate.
- Net capital gains from selling collectibles (such as coins or art) are taxed at a maximum 28% rate.
- The portion of any unrecaptured section 1250 gain from selling section 1250 real property is taxed at a maximum 25% rate. (More on this to come).
Cost Basis and Net Sale Price Determines the Amount of Capital Gains
An easy-to-understand example says a married couple filing jointly who have owned their home for ten years won’t owe any federal taxes on the net proceeds of the house they originally bought for $200,000 unless it sells for more than $700,000.
But for more detail and to determine how much you will pay in capital gains tax, you’ll need to know how to calculate your cost basis and net sale price. These are the numbers to plug in to determine the number of capital gains.
- Cost basis. This is the total amount paid to buy the house, including acquisition costs (origination fees and the like) and capital improvements (renovations, new appliances).
- Net proceeds. This is the final amount the home sold for after subtracting fees such as real estate agent commissions.
If you’ve sold for a profit, this equation diminishes your capital gains and places you in a better position to avoid capital gains taxes.
Tax Implications for Homeowners Selling a Rental Property
You’ve decided it's time to sell your rental, either because the allure of landlord life has run its course or it doesn't make sense to continue with the investment, financially speaking. Before hiring a real estate agent to put the For Sale sign in the yard, educate yourself on what the sale finances encompass. Cashing a proceeds check won’t be the only financial transaction; more likely than not, taxes on the sale will occur.
Just like your car, your rental property depreciates every year, meaning you lose value or some of the worth of the rental. But, take note; the structure depreciates, not the land it sits on. Each year, the IRS offers tax breaks on the depreciation of the home, a benefit for property owners.
However, when the time comes to sell, the IRS requires the depreciation benefit returned, otherwise known as depreciation recapture. Or in other words, if the home sells for more than the depreciated value, you’ll have to pay the taxes you avoided because of depreciation.
Learn more: 3 Reasons Military Landlords Should Have Their Taxes Professionally Prepared.
The amount of depreciation varies depending on the value of the rental property. The depreciation value is connected to your tax bracket, which could sit at a beneficial 0% if deployments were involved. However, the majority of military families sit in the 10% or 15% nominal tax bracket.
Underestimating depreciation recapture taxes is a common but costly mistake military landlords make, often turning what was thought to be a sure bet investment into a money pit when the sale goes through. Therefore, it's crucial to carefully conduct a profitability analysis with qualified real estate professionals early into the buying process before purchasing a rental property.
Two Common Workarounds
As a real estate investor, your goal is to maximize profit from your rental property. Although typically a substantial investment in the long term, your rental won’t always yield money. In fact, you might owe thousands in taxes when it’s time to sell. However, there are some workarounds to alleviate the tax burden, especially if serving as an active duty member.
Turn Your Rental Property into Your Primary Home
Moving into your rental home long enough to meet the capital gains exemption requirements is a possibility, but forecasting a long-term stay in one house is a difficult feat to conquer while serving active duty.
These are the requirements to qualify for the exemption.
- Two years of ownership is required for the five-year time frame ending on the date of the sale.
- The property has to be the primary residence for a minimum of two years of five, ending on the date of the sale.
- Exclusion from gains from income cannot be claimed in the previous two years.
The 1031 Exchange
The number 1031 refers to Section 1031 of the Internal Revenue Code. Buyers may also hear “like kind exchange” in reference to a 1031. The 1031 allows the homeowner to sell their rental home and reinvest the money into a like kind asset.
Homeowners consider this exchange if they anticipate hefty capital gains taxes, save on the depreciation recapture, or if a fast transaction is necessary. Under a 1031, the owner does not recognize losses or gains. Capital gains taxes are deferred until the property is sold. A 1031 does not negate taxes; it simply pushes the due date for payment down the road.
A 1031 exchange must also meet these criteria:
- Investment property, commercial property, personal property, and trade property are the only types eligible. Personal residences are not.
- Like kind property exchanges have to be the same: real property=real property, not real property=personal property.
- A 45-day time frame is set to identify the exchange.
- The sale proceeds are required to be reinvested in like kind property and close within 180 days.
A 1031 exchange is a complicated matter requiring a professional intermediary with years of experience.
The Next Time You Buy a Home, Prepare an Exit Strategy
Successful home sellers buy their homes with an exit strategy in mind. However, without a detailed investigation of what selling options look like in three, five, or ten years down the road, you’ll undoubtedly be taken aback as to how profitable your real estate purchase was in reality. Rental properties, in particular, have a precise profit and loss equation that needs solving to avoid unknown taxation.
Don't ignore the limits of your initial real estate investment. Prepare not only for the initial money required to purchase the home, but also to leave the property with as much money in your pocket as possible. This is an important part of homeownership often overlooked.
By Dawn M. Smith