Taxes are unavoidable. Whether you sell something small like a textbook, a service, or even a car, Uncle Sam always wants a slice of the pie. Even more so when you sell a house! There are many tax consequences when you sell a house. While the word “consequences” typically has a negative connotation, here, we use it in a neutral light.
That is, you can usually catch a tax break if you simply change homes throughout the course of a year, but you can also easily find yourself in hot water if you avoid paying taxes on the home if you make over a certain amount of financial gain from the sale of your home.
In this article, we’ll discuss all the tax implications involved with selling real estate. This way, you can be sure to cover all of your bases and be sure you are paying any tax you might end up owing on time and in full.
Will I pay taxes if I sell my house?
Before 1997, there was a tax exemption for young homeowners in place. Basically, the rule said that until you were 55, you had the option of just one time writing off up to $125,000 in gain from the sale of your home, if and only if it was your primary residence.
However, for the past 20 years, things have been a little bit different. They’ve actually changed for the better.
Now, it doesn’t matter how old you are. You can write up to $250,000 in financial gain off on your tax return. A married couple filing jointly can also write off up to $500,000. Under this new system, most people won’t have to pay any taxes on the sale unless they have lived in the home for less than two of the previous five years.
How can I qualify for the tax-free gain program through the IRS?
There are a few requirements from the IRS to qualify for the tax-free gains program when selling your home. They are as follows below:
- You must pass the “ownership test.” That is, you must have lived in the home for at least two years. So living in the home for only a short term of time would not be useful for this.
- You must also have lived in the home as your main home for at least two years. This is what the IRS calls the “use test.” If you only live in a home for part of the year (like a vacation home) you need to be really careful about this one. Especially if you rent out your home for any of the time that you are not there (even just on something like Airbnb).
- During the previous two-year period (which you determine by counting back two years from the closing date on the home) you did not write off a gain from the sale of another home in your taxes.
So basically, you need to make sure you are following the 2-2-2 rule when you report the sale to the IRS and you should be able to remain tax-free.
Next Steps: Calculating Taxable Gains on a Home
To find out what your capital gain on a certain home could be, all you need to do is to take the original amount that you paid for a house and then take away the costs it took to sell the home, less any money you invested into making the home better.
So, for the sake of this example, pretend you spent $150,000 on your home and then an additional $50,000 on additions and improvements to your home. So, the total cost basis is $200,000.
Next up, you look at however much your house sells for, take away any commissions and fees. So, let’s say you sell your house for $250,000 and since you used Clever, you only pay $3,000 in commission. You would then “take home” $247,000 in this instance.
The capital gain is this example is $47,000 because it’s the difference between the money you invested into your home and the money you got back from it. If you meet the 2-2-2 rule, you don’t have to pay any taxes on this gain. You can simply pocket it, or use it for the purchase of your next primary residence.
A quick note on financial losses when selling a home: if you sell your home for less than its original purchase price, then, unfortunately, you cannot write off this loss when filing your taxes for that year.
What happens if I exceed the nontaxable limit?
No matter what tax bracket you’re in, sometimes the rapid appreciation of real estate can leave you with a property that is now worth much more than when you purchased it. If the sales price of your home nets you more than $250,000 of profit (or $500,000 for married couples filing jointly), then you will owe some taxes because you have exceeded the minimum you can write off. This surplus amount of money will be taxed at the capital gains tax rate.
Remember, when you make any sort of improvements to your home it is so important to keep careful records of it so that you can add these expenses to your cost basis and maybe even get out of paying some taxes.
What happens if I don’t follow the 2-2-2 rule?
If you’ve owned the home you are selling for less than one year, then the IRS simply charges you on any taxable gain you make over the limit at the ordinary income tax rate. If you have lived there for longer than one year, then you will only be charged the capital gains tax rate, which is usually significantly lower than your normal income tax rate.
The main reason, however, that this 2-2-2 rule exists is not to punish homeowners who need to sell soon after purchasing a home for various reasons, but rather to ensure that home investors and others who purchase and sell real estate for profit are not able to completely avoid paying taxes on their incomes.
Although the IRS doesn’t always have the best reputation for being thoughtful and fair, the reason this rule exists actually puts the organization squarely in these two categories. They are simply trying to ensure that real estate professionals pay their fair share of taxes on their income, just like the rest of us do.
This is because if you were able to write off the income earned from homes that you lived in only briefly, or never truly lived in at all, then there would easily be the potential for people to make millions of dollars in nontaxable income each year.