Taxes, taxes, taxes. One of the more elusive aspects of real estate, and also the one nobody ever wants to think about. For the most part, any profit from home sales is not subject to being taxed, due to the 1997 Taxpayer Relief Act passed by former President Bill Clinton. While this is the general case, there are some exceptions to this act where there are tax payments required on a portion of the sale. Being aware that this is a possibility prior to selling will help ease some of the general stress in the process. Most people do not anticipate having to pay taxes on home sales, but we want to make sure to educate you on what instances could find taxations. It does not hurt to be overly aware, even it never applies to you.
Property taxes can be an overwhelming topic and full of confusing jargon, which is what puts most people off from equipping themselves with knowledge ahead of time. Rather than educating, people often avoid the topic altogether, which, in the end, could end up financially scarring them. We hope to simplify and clarify the topic of taxes by discussing who qualifies for tax-exemptions.
How Do I Know If I Will Have to Pay Taxes?
The answer to this depends on a few factors. If you have owned and lived in the home for two of the five years prior to the sale, then up to $250,000 of the profit will be tax-free. If you are married and file a joint tax return with your spouse, this amount doubles to $500,000. These amounts would be considered exclusions from your regular taxable income, however, if you sold at a loss, you do not receive a deduction of any kind. So what if your profit exceeds either of these two limits? However much rolls over must be reported as a capital gain on Schedule D. We will discuss capital gain in Part 2.
Qualifications for Tax Break from Selling a House
There are three things that must be true in order for you to qualify for tax-free income from your house:
- Ownership. You must have owned and lived in the home for a minimum of 24 months (2 years) within the 5-year period prior to the sale date. You might be wondering why they specify the five-year time frame. This would be in the event, for example, that you lived in a home for a period of time and then rented it out to a tenant for one to three years before the sale date. In that case, you would still qualify as long as you lived in the home for two of those years within the five-year time frame.
- Residence. As we mentioned before, in order to qualify for tax exemption, the house in question must have been your primary residence for at least two of the five years prior to selling.
- No other exclusions. You cannot have used the tax exemption for profit from a home sale on another house within two years prior to the current sale.
If you are still unsure whether or not you qualify, read through this list and make sure you do not fit under any of these:
- You did not live in the house for at least two years within the five-year time frame preceding the sale. (However, there are special circumstances for certain qualifying people, for example, those with disabilities or service members in the military. We will discuss this further in the next section.)
- You did not own the property for two years or more within the five-year time frame preceding the sale.
- The house was not your primary residence
- You claimed the $250,000 or $500,000 tax-exempt income on another home within two years prior to the current sale date.
Two circumstances which will automatically disqualify you, regardless of special circumstances are:
- You purchased the home through a like-kind exchange, also known as a 1031 exchange which involves swapping one investment property for another, in the past five years.
- You are subject to expatriate tax.
What If I don’t Qualify?
- Servicemembers, Foreign Service, intelligence agencies. A person who falls under this category can elect to have the five year period for residency suspended for up to ten years during any period of time that they or their spouse serve on “qualified official extended duty” as a member of the military, uniformed services, Foreign Service, or federal intelligence agency. Qualified extended duty constitutes as a period of time for more than 90 days where you are stationed at least 50 miles from your primary residence or residing in government housing under government orders.
- Those with disabilities. If you become physically or mentally unable to care for yourself, you simply need to show that your home was your residence for 12 months out of the 5-year time frame leading up to the date of sale. Any time you may have spent living in a care facility also counts toward your residence requirement, as long as the facility in question holds a license from the state or other political entity that certifies them to provide care for those with your condition.
- Divorcees. If you were separated or divorced before the sale date, you can treat the home as your residence if you are the sole or joint owner and the divorce or separation agreement enables your former spouse to live in the home and consider it as his or her main residence. If the home was transferred to you (regardless if in connection with a divorce or not) you may count any time when your spouse owned the home as the time that you owned it as well, as long as you meet the residency requirement on your own.
- Widowers. If your spouse passes away and the surviving spouse does not remarry before the home is sold, the surviving spouse may count the time the deceased spouse owned and used the property towards qualifying for tax exemption. As a widow, you may also potentially qualify for the higher amount of $500,000 of exemptions if: 1) You sell your home within 2 years of your spouse’s death, 2) You have not remarried at the time of sale, 3) Neither you nor your late spouse used the exemption on a different home sold less than 2 years before the date of the current sale, and 3) The 2-year ownership and residency requirements have been met.
What If I Still Don’t Qualify for a Tax Exemption?
If you’ve gone through the list from top to bottom and are still unsure whether or not you qualify for a total exemption, it is possible you could still qualify for a reduced exclusion. This usually occurs in the event that:
- You need to make a sudden move due to a work-related change. Specifically, if you transfer to a new job that is 50 miles or further than your last job was from the property. For example, if your current job is 10 miles from your home but your new work location is 60 miles away. This also applies to your spouse as well. In addition, if you take on a job after previously being unemployed and that job is 50 miles or further away, you may qualify.
- Move due to health-related issue(s). If you must move to help care for an ailing family member or loved one, or you yourself are seeking long term care for a health-related issue, you may qualify.
- Something unforeseeable occurs.
- Your home was destroyed or suffered casualty due to a man-made or natural disaster.
- A spouse, co-owner, or any resident of the home dies.
- You became divorced or legally separated.
- You or your spouse gave birth to two or more children in the same pregnancy.
- You became eligible for unemployment compensation.
- Loss of ability to pay for basic living expenses due to extenuating circumstances.
For a more detailed look into who qualifies, visit the IRS’s Publication 523, which contains helpful Introductory Material for those selling their home and wondering about taxes. Now that you probably have a good idea of whether or not you qualify for tax exemption for the income from the sale of your home, stay tuned for Part 2 of Everything You Need to Know About Taxes and Selling a Home, which will tackle more complex subjects such as your tax return, gain on sale and capital gain, adjusted basis, and more.