With the California home market going gangbusters this year, many families are hoping to cash in. In such a strong seller’s market, it’s tough to be a buyer. Some are choosing to sell and move to less expensive places or even switch to renting. Before and after selling a home, it’s important to consider how sale proceeds will be treated for tax purposes.
Clients rely on the tax professionals at Ferguson Timar to guide them through the implications of complex transactions like home sales. If you are thinking about selling your house, consider giving us a call first so tax planning can become a part of the process.
Selling a home and capital gains
In a booming market, most homeowners in California probably paid less for their homes than their current market value. Because houses are long-lived assets, proceeds from the sale of a home fall under the umbrella of capital gains taxes. Due to their unique character, homes enjoy special treatment in the tax code that may shield gains on a sale from taxes.
Under the home sale gain exclusion, which is present in both federal and state tax law, a couple who files jointly can exclude up to $500,000 in capital gains from the qualifying sale of their home when reporting their taxable income. Single filers can exclude up to $250,000. In many parts of the country, these limits are high enough to give most homeowners relief. But in Orange County, where the median home price is around $1,100,000, people who have been in their homes for a decade or more can end up with proceeds that are more than the exclusion limit.
Protecting a family’s wealth
The home sale gain exclusion–sometimes called the primary residence exclusion–is intended to respect the importance place a family home has in a family’s overall wealth. As such, the exclusion only applies to the sale of a home that meets these criteria:
- The home must have been the taxpayers’ primary residence for at least two of the five years preceding the sale; and
- The taxpayers must have owned the home for at least two of the five years preceding the sale.
- The taxpayers claiming the exclusion may not have claimed it on another property in the two years prior to the sale transaction.
Note that the two-in-five rules overlap. Someone who rented a home for two years and later purchased it, only to move out and rent it to someone else, could still qualify for the exclusion. Likewise, someone who lived in a home for a year, rented it to someone else for three, and then moved back in for the last year could qualify as well. This is one reason landlords like to retake possession of properties they intend to sell.
How is gain on the sale of a home calculated?
The tax basis the taxpayer has in the home will determine the tax work surrounding the sale.
Tax basis is the technical term used to describe the costs paid for an asset. In addition to the home’s original purchase price, the tax basis includes a wide variety of other expenses.
What qualifies for inclusion in a home’s tax basis gets complicated. It includes costs paid in association with the original home purchase, as well as any upgrades and renovations. Although new windows, the installation of a new oven, or the addition of a new master bedroom qualify towards an increase in your overall tax basis, general repairs and improvements that no longer exist do not. For example, if you installed a new kitchen in 1995 but tore it down in 2014, you will have lost more than those new countertops–the ability to utilize it towards your tax basis is also gone.
For homeowners who have stayed organized but incurred many expenses to upgrade their house over the years, calculating tax basis can be a big job. A complete breakdown of how tax basis works can be found in IRS Publication 523—Selling Your Home.
In comparison, the net proceeds of a sale are easy to calculate. You will reduce the sale price by considering expenses associated with the sale, such as the agent’s commission and closing costs. The IRS has taken a flexible approach regarding what counts as expenses. For example, if you pay to have your home professionally staged those are justifiable selling costs that will reduce net proceeds.
Subtracting tax basis from the net proceeds will lead you to the final gain. If the home sale gain exclusion applies and the final gain is within the exclusion limit, congratulations—the gain does not need to be reported.
Calculating capital gains
Some will owe capital gains taxes despite the home sale gain exclusion—or because they have not owned the home or lived in it long enough to qualify for the exclusion in the first place. Any amount more than the exclusion becomes subject to capital gains tax. The amount of that tax depends on the length of time the taxpayer owned the home and the taxpayer’s income bracket.
If the taxpayer owned the home for less than one year, chances are that the home sale gain exclusion does not apply. What’s more, any gain on the sale will be treated as short-term capital gain, which is taxed as ordinary income. In ordinary times such a homeowner might not expect a windfall from owning a home for so short a time, but in 2021, the issue of short- versus long-term capital gain can be significant.
For most homeowners, any portion of proceeds that do not qualify for the home sale gain exclusion will be subject to long-term capital gains taxes, determined by the taxpayer’s tax bracket. Taxpayers who will owe taxes on their sale proceeds may need to make quarterly payments to the IRS to avoid a penalty.
Ready to sell a home? Call Ferguson Timar.
This blog post only scratches the surface of what homeowners may need to consider as they plan for the tax consequences of selling their home. Ferguson Timar is looking forward to walking you through the details. Call us at (714) 204-0100 or send us an email to make an appointment with one of our tax experts.