Capital Gains Tax Exclusion for Homeowners

Clients who recently sold long-time primary homes had questions about the tax impact of the sale. Several misunderstood how capital gains would be taxed on the sale. They were unaware the former “rollover provision” (deferral of all capital gains if purchasing a new home of equal or higher value) had not been in place for 28 years! The Taxpayer Relief Act of 1997 fundamentally changed how capital gains on home sales are treated, creating the rules largely in place today using the “Section 121 Exclusion.”

This capital gains tax exclusion enables homeowners who meet specific requirements to exclude up to $250,000 (or up to $500,000 for married couples filing jointly) of capital gains from the sale of their primary residence. In most cases, if you sell your home and realize a gain of less than $250,000 (or $500,000 if married, filing jointly), you will not need to pay capital gains tax on that amount. However, there are certain criteria that must be met to qualify for the home sale exclusion: ownership, use and timing rules.

· Sellers must have owned and used the home as their primary residence for at least two of the five years prior to the date of the sale. The two years do not have to be a consecutive, single block of time during the five years.

· Sellers can only claim this exclusion once every two years. If gains were excluded from a previous sale within the last two years, the exclusion will not apply.

· The exclusion applies only to gains from the sale of a home's sale, not losses. Any portion of the profit exceeding the $250,000/$500,000 limit will be subject to capital gains tax.

· If the home sale profit exceeds the exclusion limit, capital gains tax must be paid on the amount surpassing the limit. For example, a single taxpayer realizing a capital gain of $350,000 would pay capital gains tax on $100,000 of the gain. The capital gain would be reported on IRS 1040 Schedule D.

There are some exceptions to the 121 exclusion rules: transferring a home to a spouse; when the primary home sale is sold due to separation, divorce, or death of a spouse; and in situations involving US military service members, such as "qualified official extended duty".

The sale of vacant land, sale of a destroyed home, like/kind exchanges, or investment property with business or rental income trigger different tax rules, requirements, and tax treatment. In some cases, a partial exclusion of gain may occur if the home sale was due to a change in workplace location, a health issue, or an unforeseeable event.

Keep detailed records about your home: purchase price, capital improvements made to the property, and selling expenses related to the sale. This will provide the “adjusted basis” - the cost of the home adjusted for tax purposes by improvements made and deductions taken. This helps calculate the capital gains, and determines the exclusion amount and the amount of capital gains tax due. Capital improvements add value to your home, prolong its life, or give it a new or different use: a new roof, renovated kitchen, swimming pool, or central air conditioning. Routine maintenance expenses and minor repairs cannot be added to the basis for your home. Note that certain factors (e.g., any depreciation claimed for the home), can affect capital gains tax.

The federal capital gains tax rate depends on the taxpayer’s income and whether the gain is considered long term or short term. Long-term capital gains tax rates are generally lower than ordinary income tax rates (0%, 15% or 20%.) State or local taxes may also be due related to the sale of your home. The federal capital gains tax home sale exclusion is uniform across the U.S., but taxation at the state level varies.

You generally need to report the sale of your home on your tax return if you received a Form 1099-S. This form is provided by the closing agent to report proceeds from real estate transactions. The home sale must be included when filing your return, even if there is no taxable gain. Consult with a tax professional to ensure you take full advantage of any available tax benefits, both federal and state. For more information, see IRS Publication 523.

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Best regards,

Janet Rhodes Friedman, CFP®, CDFA®, MBA

Janet@PlanWithFPS.com

617-630-4978

Financial Planning Solutions, LLC (FPS) is a Registered Investment Advisor. Financial Planning Solutions, LLC (FPS) provides this blog for informational and educational purposes only. Nothing in this blog should be considered investment, tax, or legal advice. FPS only renders personalized advice to each client. Information herein includes opinions and source information that is believed to be reliable. However, such information may not be independently verified by FPS. Please see important disclosures link at the bottom of this page.