Liz Weston: How to lower taxes when you sell your home
If the value of your home has gone up, congratulations. If you decide to sell, be careful.
Financial adviser James Guarin says some clients don’t realize that income from the sale of housing is potentially taxed until their profitability is prepared – and by then they may have spent the money or invested in another home.
“They’re not happy vacationers when they learn that Uncle Sam not only taxes this as a capital gain, but they also get some risk at the state level,” says Guarino, a chartered accountant and certified financial planner in Woburn, Massachusetts.
Long-time homeowners who took advantage of previous tax rules that allowed people to transfer profits from one home to another could expect a particularly unpleasant surprise. These old rules can trigger taxes, even if you are below the current exemption limits of $ 250,000 per person.
Understanding how income from selling housing is calculated – and how you can legally reduce your tax bill – can save you money and stress if you plan to make money on the current housing price boom.
How tax rules have changed
Until 1997, home sellers were not required to pay taxes on their income if for two years they bought another house of equal or greater value. In addition, people aged 55 and over can use the one-time exemption to avoid paying income taxes on the sale of housing of up to $ 125,000.
The 1997 Taxpayer Benefits Act changed the rules so that instead of transferring income to another home, homeowners could exclude up to $ 250,000 in income from the sale of housing from their income. To qualify for a complete exemption, home sellers must own and reside in the home for at least two of the five years prior to the sale. Married couples could provide shelter of up to $ 500,000.
These exclusion limits have not changed in 25 years, and the cost of a home has almost tripled. The average sale price at the time of the law was $ 145,800, according to the Federal Reserve Bank of St. Louis. The median was $ 428,700 in the first three months of this year. The median means that half of the homes are sold cheaper and half more expensive.
The availability of taxable income from the sale of housing has been relatively rare outside of luxury real estate and expensive cities, but this is no longer the case, financial advisers say.
Why your tax base matters
Your first step in determining profit is to determine the amount you received from the sale. This is the sale price minus any selling expenses such as real estate commissions. Then determine your tax base. This is usually the price you paid for the house, plus certain costs to close and improve. The higher the base, the lower your potentially taxable income.
Let’s say you got $ 600,000 from a home sale. You originally bought it for $ 200,000 and remodeled the kitchen for $ 50,000. You have to subtract that $ 250,000 from $ 600,000 to get $ 350,000 in capital gains.
If you are single, you can deduct $ 250,000 from your income and pay tax on the remaining $ 100,000. (Long-term capital gains are usually taxed at 15% federally, although large enough profits can push you to a higher 20% capital gains. State tax rates vary.) If you’re married and can exclude up to $ 500,000 in profits, you don’t have to tax.
Your taxation may be lower than the purchase price, however, if you have previously deferred income from home sales, says CPA Mary Kay Foss of Walnut Creek, California. Let’s say you sold a house before 1997 and made $ 175,000 in a new home, which cost you $ 200,000. The initial tax base of your home will be only $ 25,000. Now that you realize $ 600,000 from the sale, your capital gain will be $ 525,000, even with a $ 50,000 kitchen remodel.
Other factors may increase the tax base and reduce potentially taxable income. For example, if you had a house with a deceased spouse, at least half of the foundation of the house would be “increased” or increased to its market value at the time of your partner’s death. If you live in a state-owned state such as California, both halves of the home receive this step on a tax basis.
How to reduce profits
Another way to strengthen your foundation: home improvement. To qualify, improvements must “increase the value of your home, extend its life, or adapt it to new use,” according to IRS publication 523, Selling Your Home.
Extras in the room, updated kitchens and a new amount of plumbing; repairs or maintenance, such as painting, are usually not performed. You also don’t count the improvements that were later ripped off or replaced.
Home sellers should carefully read publication 523 to understand what costs can reduce their profits, and keep records – such as checks – in case they are audited, says Susan Allen, senior manager of tax practice and ethics at the U.S. CPA Institute.
“Be active in the recording service because we all know that if you come back in 10 years and look for something, it’s much harder to find,” Allen says.
Liz Weston is a columnist for NerdWallet, a certified financial planner and author of “Your Credit Score”. Email: lwestonnerdwallet.com. Twitter: lizweston.