As anyone who has ever sold a home can attest, the process is a mixed bag of emotions- excitement, nervousness and filled with bittersweet memories. While most sellers have adequate representation to help guide them through the process of the sale- realtors, real estate attorneys, and the like- few sellers know where to turn when it comes to determining the taxability on the sale of real estate. Furthermore, few sellers understand that the sale of their own personal residence can be a taxable transaction.

The fact is, most homeowners will never pay capital gains taxes when they sell their home. This is because the IRS rules for the “Home Sale Gain Exclusion” allow homeowners to exclude $250,000 of gain if single and $500,000 of gain if married. However, there are many stipulations that must be satisfied the ensure a taxpayer is eligible for this exclusion the most important being that it only applies to a taxpayer’s “principal residence.” This means that properties held for investment, including raw land do not qualify. Furthermore, it is important to note that even if you meet the eligibility requirements to use the Home Sale Gain Exclusion, a gain on the sale of a principal residence over $250,000 (or $500,000 if married) is a taxable transaction subject to capital gains taxes. While these exclusion amounts seem large, it is not difficult to have a gain of this size if you have owned the home for a long period of time, are in a hot housing market, or if the initial purchase price of the home was large.

How are capital gains calculated on the sale of a home?

The calculation of gains on the sale of the home follow the same rules as any other asset. The gain is the difference between the sale price of the property and the adjusted basis. When you sell the home, you are eligible to deduct from the sale price the following expenses- realtor commissions, advertising expenses, and any seller paid loan charges (charges the seller pays on the buyer’s loan). These expenses help reduce gains.

What is adjusted basis and why is it so important?

Adjusted basis is the accounting term for the amount of money you’ve put into your home. Your adjusted basis typically includes: the purchase price and the costs to acquire the home (legal fees, survey fees, title insurance, transfer or stamp taxes) and the costs of additions and improvements. It is important to note that “additions and improvements” does not include maintenance or repairs. For example, painting your house does not increase your adjusted basis.

If the property is owned for investment purposes, the process of calculating adjusted basis becomes both more important and more difficult. Why is it more important? When you sell an investment or rental property, you are not eligible for the “Home Sale Gain Exclusion” because the property is not your primary residence. This means any amount of gain will be taxable. Why is it more difficult? Property held for investment can be depreciated and items of maintenance can be expensed. This is helpful to owners of investment real estate, because depreciation and maintenance expensing help reduce yearly income tax. However, depreciation must be subtracted from adjusted basis meaning that the potential taxable gains on the sale of investment real estate are larger. Furthermore, when you have taken depreciation, then sell the property for a gain, the property will be subject to “Section 1250 Depreciation Recapture.” This typically means that part of the gain is taxed at the higher Section 1250 Depreciation Recapture rate of 25% and part of the gain is taxed at lower long-term capital gains rates.

Whether you are holding property for investment or as your primary residence, it is important that you keep accurate records regarding the total acquisition cost (purchase price, fees, etc.), costs associated with additions and improvements and any expenses incurred when you sell the property. If you own a property for investment or rental, you will need the expertise of a CPA to keep track of your adjusted basis- these calculations are not easy, and it can often be extremely difficult to distinguish between costs considered “additions and improvements” which increase adjusted basis and items of maintenance which do not.

The amount of time you lived in your home can affect the taxability of gains.

The fact that a home was used as your “primary residence” does not guarantee your eligibility for the Home Sale Gain Exclusion. Additional requirements must be met. For starters, you must have used the home as your main home for at least two of the five years prior to the sale. Furthermore, you are generally ineligible if you’ve used the Home Sale Gain Exclusion from the sale of another home in the two years prior to the date of the sale.

There are certain exceptions to the “two out of five years” rule in the event of unforeseen circumstances but the rules here can get complicated. Generally, if you need to move for work and have lived in your home for less than two years, you will be eligible for partial usage of the Home Sale Gain Exclusion if you move more than 50 miles away from your old home. Other exceptions apply but this is the most common exception.

If you own multiple homes, or if the time period the home was your primary residence is close to the two-year requirement, it is critical that you document the time spent in the home accurately. The two-year requirement does not have to be consecutive. For example, if you spend half the year in your home in Florida and half the year in your home in Chicago, the half year spent in Florida counts towards the two-year requirement. However, during an IRS audit, you may need to prove that you actually used the Florida home as your primary residence and have records as to the length of time it was used. The IRS is very specific on what can and cannot be counted as a day of occupancy. This is why accurate and thorough documentation is key.

How can I avoid paying taxes on gains on investment properties?

                Through a quirk in the tax code, the IRS allows owners of investment properties to defer the recognition of gains on those properties if they use the sale proceeds to acquire a “like-kind” property. Also known as a section 1031 exchange or a delayed exchange, this allows the investor to defer both capital gains taxes and depreciation recapture taxes. The rules on 1031 exchanges are very complex, but here is a highly simplified overview.

The first requirement in a delayed exchange is that the proceeds from the sale of the first property cannot be transferred to the seller, they must go to a “qualified intermediary” who will hold the funds until the second property is purchased. Second, the investor must identify the replacement property within 45 days of the sale of the first property. Third, the replacement property must be purchased within 180 days of the sale of the first property. If the investor meets these requirements, she will not have to recognize the gain from the sale of the first property. The gain will only be recognized when she ultimately “cashes out.” Keep in mind that this strategy does not reduce the tax liability, it only defers the taxes to a later date.

1031 delayed exchanges can be useful in a variety of situations- when an investor is looking to gain exposure to a different geographic region, to diversify with more units, or to gain exposure to a different price level. Furthermore, because the depreciation taken on a property increases over time, the amount of gain eligible for deferral through a 1031 exchange increases over time.

Using delayed exchanges can be a valuable estate planning technique. If the owner of the property leaves the investment in real estate through 1031 exchanges, the property will ultimately be eligible for a step-up in basis upon the owner’s death resulting in a more favorable tax situation when the property is sold. One caveat to using 1031 delayed exchanges as part of an estate plan applies when the owner’s estate will owe estate tax. Real estate is an inherently illiquid asset and if estate tax is owed, additional planning must be done to ensure funds are available to pay any estate taxes due. This is in contrast to more liquid assets like financial securities which are also eligible for a step-up in basis and can be sold quickly with low transaction costs thereby mitigating those additional planning needs. Furthermore, properties held outside the owner’s state of residence will be subject to ancillary probate unless ownership is transferred to a trust. Both of these options feature additional legal complexity. As always, the benefits of using this technique must be weighed against the costs.

A 1031 delayed exchange cannot be used for a personal residence. For example, you cannot sell a home for a $750,000 gain and then acquire a new home and defer recognition of the gain (at least $500,000 of gains would be taxable in the current year or $250,000 if married).  Personal residences are eligible for the Home Sale Gain Exclusion and by definition are not investment properties. However, an opportunity exists to use both a 1031 delayed exchange and the Home Sale Gain Exclusion if the owner converts a personal residence into an investment property and meets the eligibility requirements. Again, this is a complex transaction requiring professional assistance and guidance.

Delayed exchange techniques can get extremely complicated and there are many requirements that must be met to maintain eligibility to defer recognition of gains. It is imperative to consult with a CPA who is well versed in these exchanges. Failure to do so can result in significant adverse tax consequences.

The Bottom Line

Whether you are buying or selling a home for personal or investment use, it is critical to consider the tax consequences of these transactions as well as the documentation required to prove the accuracy of the adjusted basis or eligibility for gain exclusions. If you own property for investment purposes, you will need the expertise of a CPA to accurately account for the yearly income tax impact, depreciation deductions, and adjusted cost basis. Regardless of whether the property is used for investment or as a primary residence, accurate record keeping is imperative.

There is obvious allure to owning real estate but there are a variety of factors, both tax and otherwise, that must be considered before jumping in. While many investors believe that real estate prices go up in a straight line, this is simply not true. Whether you are looking to move, purchase a second home or purchase an investment property, if you would like an unbiased opinion on a real estate transaction, please do not hesitate to contact us.