Sounds pretty straight-forward, right? Insert “LOL”.
Are you married or single? How long did you live there and when? Was the property deeded or willed to you? What is your basis (what is basis)?
Stay with me.
If you don’t follow, just message me for clarification. Don’t be ashamed, I barely get it and I spent a Maserati on financial education.
The IRS allows you to EXCLUDE $250,000 of CAPITAL GAINS if single, or $500,000 if Married-Filing-Jointly if you meet the following conditions:
- The home is (or was) your primary residence.
- You owned the home for at least two years before selling.
- You lived in the home for two out of the last five years before the sale (the period of occupancy does not have to be consecutive).
- You have not excluded a capital gain from a home sale in the preceding two years.
- You did not acquire it through a 1031 exchange (If you don’t know what a 1031 is, you didn’t do it).
What part of the sale price is a CAPITAL GAIN?
I’ll tell you. It is the amount you receive upon sale that is ABOVE your BASIS.
What the hell is my BASIS?
Let’s look at 4 common scenarios:
1. You bought the house and lived in it the entire time
Your basis is what you paid for it plus any improvements. If you paid $200k for it and mad improvements, such as adding a deck and replacing a roof to the tune of $20k, your basis is $220k. If you are married and meet the IRS requirements that we mentioned, you can sell it for $770k ($500k + $220k basis) and pay no federal capital gains tax. You will need to keep your records of the improvements to substantiate the costs if the IRS inquires.
2. You inherited the property
Technically, you inherit a property if you received it as an heir of the previous owner. Your basis is the FMV (Fair Market Value) at the date of death, or exactly six months after death if the value is higher and you elect the alternate valuation date; BUT, if you were named on the deed before you “inherited” the property, your basis is the basis of the person you were essentially gifted the property from. This means that if Grandma bought the house in 1962 for $30k, put you on the deed at any time before she passed, and you sold the house afterwards for $280k, you had better have live there for 2 of the last 5 years before you sell the place (and meet the other IRS conditions) or you are paying federal capital gains tax on a quarter million. That’s right, your basis is her basis, $30k. If she had a properly drafted will and left you off the deed, you would have probably paid no tax.
BEFORE YOU PUT YOUR HEIRS ON A DEED, CONSULT AN ESTATE PLANNING ATTORNEY OR A C.P.A.! This could be a costly mistake that could have been avoided with a simple will.
3. You lived in the house and then rented it out
If you meet the IRS conditions for excluding capital gains that we first mentioned, you won’t have to pay them if you are in situation 1. or 2., but you will still have to pay taxes on the depreciation deductions that you took while renting it out. Depreciation recapture is 25% in most instances. For example, the depreciable basis of your property (the building only, land is not depreciable) is $275k. Each year the IRS allows you to depreciate 1/27.5th of this amount, or $10,000 in this instance. You rented it for two years before selling, so you took $20k of depreciation. You are most likely on the hook for $5k of taxes (25%) in the form of depreciation recapture although you avoided capital gains tax.
4. You “house-hacked”
You lived in one unit of a multi-family, and met the IRS conditions for excluding capital gains for that one unit. For instance, you spent 2 of the last 5 years on one side of a duplex. Half of the basis is treated as in situation 1., and the other half is treated as strictly investment property, on which you will pay capital gains and depreciation recapture taxes at varying rates. It gets even sticker if you moved out of the rental property less than three years before selling, as you have depreciation recapture on both halves of the house, but pay capital gains tax on only one half. Believe it or not, I created a spreadsheet for this situation.
We won’t address state taxes in this post, but in most cases they at least rhyme with federal taxes.