In this episode, Tax Directors Candace Varner and Ben Hake are joined by their colleague, Amy McCue, to explain how you could exclude a portion of the gains in your home’s value on your taxes if you’ve recently sold it (or are considering it in this hot seller’s market). As usual, Ben makes things complicated.
Read more about the current real estate market: https://creativeplanning.com/insights/is-it-smart-to-buy-real-estate-right-now/
The Standard Deduction podcast is hosted by Tax Directors Candace Varner and Ben Hake. This podcast is a thoughtful, informed discussion about ideas, trends and developments in taxes related to personal wealth management.
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Candace Varner: Welcome to The Standard Deduction. I’m Candace Varner.
Ben Hake: I’m Ben Hake.
Candace: And today we have a special guest, Amy McCue, a tax director with us that will be helping us talk to you guys about the home sale exclusion for your primary residence. Welcome, Amy.
Amy McCue: Thank you. How are you guys?
Ben: Doing good.
Candace: Ben, tell us what you know about home exclusions, or maybe what you think you know.
Ben: I know a little bit, but a lot of our clients have recently become aware that the housing market is really, really hot right now, house sustaining prices are up, so they’re looking to possibly sell. For a lot of individuals, you don’t sell your house every year, hopefully, so they’re not really aware of the rules. We’ve got a number of clients, they live in their house 30+ years. They haven’t sold one in a while. They actually remember some of the older rules.
Prior to 1998, the IRS said, “Hey, as long as the next house you’re buying was more expensive and you just rolled your proceeds into it, you didn’t have any gain on sale.” As long as you are buying nicer houses or a bit more expensive houses, then you never had to pay any gain. Or, there was another rule that said, “Okay, well, that all works until you turn to age 55, at which case you get a one-time ever exclusion of $125,000.”
Now obviously people move more regularly than that, so the rules changed almost three decades ago now, but Candace, tell us what the actual rules are.
Candace: I love that we’re starting with three-decade old tax law, but we still get questions about that. Clients still ask me that regularly if they have to roll it over into another house. It definitely still comes up. The current rules now state… Forget everything Ben just said. And instead, it’s not once per lifetime, but the exclusion is going to be $250,000 of gain if you’re single, or $500,000 of gain if you’re married filing joint. Now, this is a federal law, but all of the states follow this, as well, in the rare case that states actually all agree to do what the IRS says, as well.
To get this exclusion, you have to meet some criteria. The biggest one is that it needs to actually be your primary residence, and you have to live of there in two of the last five years. As long as you meet that, if your gain on your house is $500,000 or less if you’re married, you would not pay any federal or state taxes on the sale. Now, it has to be two of the last five years, but Amy, tell us some more specifics about that.
Amy: Yeah. Those two years don’t have to be consecutive. They can be any time that adds up to two years in the past five years. And then another thing to note is in the case that you’re in a loss position, that loss is not deductible.
Candace: Correct. No losses on any personal assets, including your personal residence would not be deductible. I said this isn’t a lifetime thing. How often can I claim this? What if I want to move every year?
Amy: You can only claim the full exclusion once every two years. For example, if you sold your home in October 2020 and you used the home gain exclusion and you wanted to use it again, you would want to wait until October 2022 to sell another home to get the full exclusion.
Candace: Got it. Even though I could theoretically meet more than one exclusion in the two of five years, I can only take this every other year.
Candace: And then sometimes life happens and I can’t meet those requirements. Something changed. Something unexpected. I planned to live there for three+ years, but it didn’t work out. Are there any exceptions, or am I just stuck with this two of five years?
Amy: There are some exceptions where you can get a partial exclusion, and that is going to be when you have to sell your home for some unforeseen circumstance. There can be a lot of different circumstances that might apply, but some of the ones we see the most are moving for work, which you didn’t anticipate, and also moving for health reasons, whether they’re your own health reasons or a family member’s, someone you’re taking care of. Just talk to your CPA about those circumstances that may allow you to take a partial exclusion.
Candace: What about if I’m in the military?
Amy: The military is a special exception, essentially extends the five-year rule. For example, if you live a home for two years, and then you are a member of the armed forces, the intelligence community, or the Peace Corps, I believe, and you move and you’re not in that home, say you’re either renting it out or it’s just sitting vacant, you can extend that five-year period to 10-year and suspend the five years or the time that you’re not in the home. As long as you’re in the home for two of the past 10 years, you are eligible for that full exclusion.
Candace: That’s helpful, since I know they have to move around a lot, sometimes not by their choice. Those are actually the more simple circumstances. Ben, you usually like to make things more complicated just for your own fun. How could we do that with a personal residence?
Ben: We’re talking about if you’re just like, “Hey, we’re moving out. We’re going to sell our house. We’re going to buy a new one,” or maybe not buy a new one, because we’re not in the ’90s anymore. But a lot of clients are like, “Well, maybe this isn’t the hot housing market that we have right now,” and they’re like, “We’re just going to rent it out for a little while.” Day one, you move out. You start leasing it out to somebody. That doesn’t mean your primary residence exclusion is lost.
As we’ve kind of talked about, you have to have lived in it for two of the past five years. So that means is let’s say you move out and rent it to somebody for 12 months. Because you’re still meeting that two years of the past five of living there, you’d still be able to qualify for the exclusion. We’ve had a number of clients who maybe rent it out for a year or two after they move out and are still able to qualify for the exclusion. Now, while you rent it out, you take depreciation, so there’d be a little recapture there, but relatively minimal.
The other question we get asked quite a bit is, “What if I have a rental property and I actually move into it, live in it for two years, does that mean that I can exclude all the gain from it there?” Unfortunately, the IRS likes to be a bit of a wet blanket in these sorts of situations, and that two years doesn’t make it better. What they say is, “Well, if you rented it out for nine years and then you lived in it for one, then 10% of your gain would be excluded.”
Obviously the longer you live there after it’s rented out, you get a larger portion of that exclusion, but you’ll never get 100% exclusion in those sorts of scenarios, unfortunately. Another question we get relatively often about these is, say you have a gain that’s over $500,000. Let’s say you’re selling your house and you’re making $1 million. Another common question is, “Well, I’ve done a like-kind exchange or a 1031 where I sell a piece of real estate and buy a new one. Is that an option for a primary residence?” And unfortunately, similar to moving into your rental to get the exclusion, the IRS says that that property wouldn’t qualify for 1031 treatment, at least if it had never been rented out before the sale. Just another consideration that at least that might not be an option.
Candace: We’ve got all of the rental options. We’ve got possible exclusions, possible partial exclusions. So now we’re going to go to actually calculating our gain. All of this is talking about a gain that we might be able to exclude, but how do we come up with the gain that we have on the property to begin with, Amy?
Amy: Yeah. You’re going to want to have handy your closing document from the purchase of the home and the closing document from the sale of the home. The purchase document should show what you paid for the home, and that is your cost basis or original purchase price in the home. Then you would subtract that from the selling price of the home. There’s a couple other adjustments to add in there before we get to the final gain. You also want to add any large improvements that you’ve made to your home that increase the value of your home.
You get to add those to the cost or the basis of your home. Those would reduce the gain. Things like a new roof, or maybe you added an addition to your home, things like that are added to your basis. And then the last thing we want to look at is the selling costs or the closing costs on the sale of the home. Those are a deduction in coming to the gain on the sale. Altogether you have your sales price, less your closing costs, selling costs, less the basis in the home, which includes improvements.
Candace: Excellent. We’ve done all of that work, and we’ve decided, okay, my whole gain on the house is, let’s say $300,000. I’m going to get to exclude all of that, because I am married and I have up to $500,000 to exclude. I’m done, right? Except no. The IRS still wants to know about it, even though it’s not going to end up being taxable. When you sell your house, you’re going to get a tax form the following January, a 1099-S, and it’s going to show only the gross proceeds.
If I sold the house for $1 million, it’s just going to say you got $1 million. You have to report that on your tax return, along with all the other capital gains transactions to say, “Yes, I got the $1 million, but here’s all my basis and here’s why I qualify for this amount of exclusion.” If you report nothing, which I’ve seen many times, the IRS will assume that entire $1 million was taxable, because you didn’t report any basis information to them.
You will definitely get a letter from them saying, “How come this wasn’t on your tax return?” And maybe they’re going to try to assess tax on the entire thing. Obviously they’re wrong, but it’s easier to just put it on your tax return, show that it’s not taxable, and head that off before they ever even ask about it. Ben, any last thoughts on selling your home?
Ben: No. Hopefully our listeners are able to enjoy the market that’s very hot right now, and just be aware that as they start to sell, they can hopefully collect some of that old information on when they bought it, and hopefully pay very little tax on that. Thank you everyone for listening.
Candace: Thank you.
Disclosure: This commentary is provided for general information purposes only and should not be construed as investment, tax, or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable, but is not guaranteed.