This is a guest post from H&R Block. The opinions and views are those of the author. Matthew Stewart Real Estate Team does not give tax advice. Since each homeowner’s tax situation is unique, you should always consult with and rely on the advice provided by your tax advisor.
When it comes time to sell or rent out their home, homeowners should not only consider the real estate market and their home equity, but their taxes as well. That’s because some homeowners may face capital gain tax as high as 20 percent on some of the gain on the sale of their homes, while others can avoid that tax entirely. Whether or not a homeowner faces any capital gains tax on the sale of their home depends on the amount of their gain and how long and how recently they lived in the home.
A $250,000-$500,000 tax exclusion
The tax code excludes from tax the first $250,000 of gain from a home sale. For married taxpayers filing jointly, the maximum exclusion increases to $500,000. Many homeowners will not see that kind of gain on their home sale, especially after they take into account improvements they’ve made over the years, which add to their basis in the house. To qualify, an improvement must add to the value of the home, prolong its life or adapt it to new uses. Maintenance costs, such as painting the home, do not count as upgrades increasing a homeowner’s basis.
If a married couple bought a home for $150,000 in 1996 and sold this home in 2016 for $175,000, their gain is only $25,000 and well below the capital gain exclusion threshold, even before the homeowners take into account the value any improvements added to their basis in the home.
Other homeowners will need their qualified improvements to reduce their taxable gain. For example, if a single homeowner bought a fixer-upper for $100,000 at the bottom of the housing market and, after putting considerable work into the property and watching property values increase in his neighborhood over many years, sold the house for $400,000, he would potentially have to pay taxes on $50,000 in gain. But if he spent $150,000 to improve his home, such as adding a room and upgrading a kitchen, his gain is now below the exclusion threshold for single filers.
Homeowners have two requirements to meet before they can qualify for the exclusion, related to the length of time they lived in the home and how they used it. To qualify for the exclusion, a homeowner must have owned and lived in the home as their primary home for at least two of the previous five years.
Brief rental window before possible loss of tax exclusion
After the recent housing crisis, some homeowners who needed to move out of their homes, perhaps because of a new job, may have decided to rent them out until their houses’ value reached a certain point. Depending on how long they waited to sell, they may have lost their tax exclusion. Even if a homeowner owns and lives in their home for at least two years, but then rents out the home and sells it more than three years after moving out, they can no longer exclude any gain from the capital gains tax. Similarly, homeowners who are deciding between selling or renting out their house should take into account their long-term plans and their tax responsibilities. Renting out a home also has tax consequences and involves keeping detailed records of rental income and expenses.
As with all financial situations, homeowners need to consider more than just one factor, like their tax situation, when making important decisions like selling their home or renting it out. These decisions and consequences do not operate in a vacuum, but taxes are a big piece of the puzzle.
Kathy Tullius is a senior tax specialist for Block Advisors, specialists in personalized tax preparation, tax planning, small business taxes and year-round support, in Pacifica. Kathy provides expert tax advice and preparation support for taxpayers in the Bay area.