The market is red hot. In fact, Seattle’s housing market currently ranks among the fastest-moving in the nation.
More than a third of Seattle-area homes—including single-family, condos and townhouses—sell in the first week. If you extend the time period to two weeks, the percentage increases to nearly 50 percent. That makes Seattle number ten on Redfin’s April 2013 list of hot residential real estate markets.
Perhaps even more significant, the average selling price for single-family homes in Seattle has increased by 24.9 percent over the previous year, also according to Redfin. This increase in price, combined with low interest rates and a relatively low number of homes for sale, makes Seattle something of a seller’s market.
And that makes people consider selling.
If you’re one of them, a basic understanding of the federal tax consequences can help you determine the economics of selling your home.
Unfortunately, there are many misconceptions about the tax rules for the sale of a home—likely because the rules have changed significantly over the years. For example, you don’t have to be 55 to exclude gain from the sale for tax purposes, the exclusion is not a one-time tax benefit, and you don’t have to reinvest the proceeds in a new home in order to qualify.
So, what are the current rules? How do you calculate the gain or loss resulting from the sale of your home? And how is it treated for federal tax purposes?
Calculating Your Gain or Loss for Federal Tax Purposes
Your gain or loss on the sale of your home is equal to the amount you realize (selling price less selling expenses) less your basis in the home. If the result is positive, you have a gain. If it’s negative, you have a loss.
Selling price Your home’s selling price is the total value you receive in return, not just the cash at closing.
Selling expenses Relevant selling expenses include advertising costs, sales commissions, title insurance and legal fees. You cannot deduct the cost of minor repairs or other expenses incurred to make the house more saleable, like painting.
Adjusted basis Your basis generally starts with the original cost of your home, including certain closing costs—but there are exceptions. If you inherited your home or received it as a gift, and depending on the circumstances, you’ll start with its fair market value at the date of death or the basis of the person who gifted it to you. If you acquired your home in a trade, you’ll start with the basis of the home you traded for it.
Your basis increases by the value of any significant home improvements you make during the time you own the home. The basis is reduced by any gain you may have deferred under the old rollover rules for homes sold before August 5, 1997.
Selling Your Primary Residence at a Gain
Generally, you can exclude up to $250,000 of gain from the sale of your primary residence—$500,000 if you’re married and file a joint tax return. There are no age restrictions.
To qualify, you must have owned your home and occupied it as your primary residence for two of the last five years—but not necessarily the last two years. If you’re married, both you and your spouse must satisfy the primary residence requirement in order to qualify for the $500,000 exclusion, but the ownership requirement only applies to one of you.
You can qualify for the gain exclusion more than once in your lifetime, but not more frequently than every two years. That means you generally won’t qualify if you excluded gain from the sale of another home within the last two years. If you’re married and intend to claim the $500,000 exclusion, this requirement applies to both of you.
There is an exception to this two-year rule, however, under certain limited circumstances. You may be able to claim a reduced (prorated) exclusion if the sale becomes necessary as a result of unforeseen situations, such as a health issue or a change in your place of employment.
This exclusion is optional. Under certain circumstances, you may choose not to claim the exclusion and, instead, recognize the gain in your gross income. For example, you might intend to sell another qualifying home at a much larger gain in less than two years.
You can also change your decision about using the exclusion at any time within three years of the due date of your tax return for the year of the sale.
There are a number of other situations that can affect how you report the sale of your residence for tax purposes. For example, if your gain is greater than the exclusion amount, the excess is subject to tax—including the 3.8 percent Medicare tax if your income is above the related threshold. The amount of gain you can exclude may be limited if you’ve used a portion of your home for business or as a rental or if you acquired your home in a 1031 like-kind exchange.
It is also important to understand the documentation you must save, and how long to save it. Generally, you should permanently retain all real estate records necessary to substantiate the cost and tax basis of your home—including any blueprints and plans — plus any records relating to the mortgage and mortgage refinancing, settlement and closing costs, cost of improvements, and any casualty losses and related insurance reimbursements. For more information on record retention requirements, you can refer to our previous article Know How Long to Keep Those Digital or Paper Documents? Record Retention Guidelines for People, Businesses and Not-for-Profits.
Selling a Second Home or a Vacation Home at a Gain
Your vacation home or second home doesn’t automatically qualify under the exclusion rules. However, if it subsequently becomes your primary residence for two or more years, you can sell it and qualify for a slightly modified version of the exclusion.
The exclusion calculation changes if the home you’re selling was not your primary residence during the entire time you owned it. In such a case, your gain is first prorated based on the number of years the home served as your principal residence relative to the total number of years you owned it. The resulting prorated gain amount is then eligible for the up-to-$500,000 exclusion, as long as you have lived in the home as your primary residence for two of the last five years.
Selling Your Primary Residence at a Loss
For tax purposes, you can’t claim a loss on the sale of your home.
Selling a Primary Residence with an Under-Water Mortgage
In spite of recent increases in value, your home may still be under water—meaning that the amount of your mortgage is greater than your home’s selling price.
As a general rule, if you have debt—including mortgage debt—that is reduced, canceled or forgiven, the amount that you are no longer obligated to repay becomes taxable as ordinary income for federal tax purposes.
Under current tax law, there is an exception for a qualified principal residence—set to expire at the end of 2013. If debt on your principal residence is partially or totally forgiven as a result of foreclosure or mortgage restructuring, you can exclude the amount from your taxable income. However, the debt must be secured by your home, and the proceeds must have been used to buy, build or substantially improve your principal residence. If the debt was incurred in refinancing your home, it qualifies only up to the amount of the principal balance before refinancing.
Further, the debt forgiveness must derive from a change in your financial condition or a decline in your home’s value and not from any other circumstance, such as payment for services you provided to your mortgage lender.
The maximum amount excludable is $2 million, or $1 million for married couples filing separate returns.