If you sold your home recently, you're probably wondering how this large transaction figures into your income tax liability.
The U.S. tax code treatment for home sales and mortgage financing is extremely favorable, and you can save a lot of money by understanding the tax code. Before the recession, many people made a lot of tax-free income by buying and selling homes every two years or so and taking advantage of available exclusions. Knowing what the Internal Revenue Service (IRS) allows not only helps home sellers, but also helps those who plan on making a home purchase in the future.
The three key points we're going to cover here are: 1) Whether you need to report capital gains; 2) Calculating your capital gains; and 3) Deduction of points paid but not yet amortized.
Excluding capital gains from the sale of your home
In instances where you have met certain ownership and occupancy requirements, you can exclude capital gains from a home sale.
Single and separate filers whose gains don't exceed $250,000 and married couples with gains of $500,000 or less are off the hook. You are not even required to report the sale. Here are the main requirements for exclusion, detailed at IRS.gov:
- During the five years leading up to the sale, you must have owned the property for at least two years;
- In that five-year period, you must have used the home as your primary residence for at least two years. These periods do not have to be continuous, and they don't have to be concurrent. For example, if you had a lease option, you may have lived in the home while you didn't own it, and then you may have bought the property but then rented it out.
If you determine that your capital gains can be excluded, you don't have to do anything else.
There are some exceptions (as this is the IRS, there are exceptions to everything). You can still claim some or all of the exclusion in the following cases:
- You become too ill or disabled to care for yourself at home and you did live there at least one year;
- Your previous home was destroyed or condemned;
- You are a member of the uniformed services or Foreign Service, an employee of the intelligence community or an employee or volunteer of the Peace Corps;
- You have to sell involuntarily because of your employment, health or other unforseen circumstance.
If you meet the above requirements, the rest of the calculation is a no-brainer. For instance, if you sold your home for less than $250,000, obviously you didn't see capital gains exceeding the maximum--you are done.
If that's not your situation, you have more calculations to do.
Calculating the capital gain on the sale of your home
Here's how to calculate the gain on the sale of your home for the IRS:
- Take the selling price of the property and subtract the expenses of the sale (such as real estate commissions) to get your net proceeds.
- If you receive form 1099-S, the amount in 'box 2' is your proceeds. (Note: you won't receive a 1099-S if your entire gain can definitely be excluded.)
- From the net proceeds, subtract what you paid to acquire the property--which is the sales price plus closing costs (but not mortgage lender fees). You can find this number on your closing statement.
- You may have to make some adjustments. For example, if you made improvements to the property or paid a special assessment for local improvements, you subtract those costs from your gain. When sellers pay points to lower buyers' mortgage rates, those amounts must be added back. If you ever rented the home out and deducted depreciation, you have to add the amount deducted back in when calculating your gain.
Example of capital gains calculation:
John sold the home he owned and lived in for the last eight years for $600,000, and he is not married. He calculates his gain as follows:
- Sales price is $600,000;
- Subtract $20,000 in selling expenses to get $580,000;
- Add back $5,000 for the points that the seller paid when John purchased the home--balance is $585,000;
- Subtract the $70,000 that he spent renovating the kitchen--balance is $515,000;
- Finally, subtract what John spent to buy the home. The purchase price was $200,000 and his closing costs (excluding loan fees) were $3,000, leaving a balance of $312,000.
That $312,000 would all be taxable income if John didn't qualify to exclude his maximum of $250,000, but he does. So he only has $62,000 of income from the sale of his home subject to income tax. He reports this amount on Schedule D and will pay the long-term capital gain rate of 15 percent.
Another exception from the IRS determining your capital gains: If you received the home as a gift or inheritance or you are a surviving spouse, your basis is calculated from the fair market value of the home when you received it.
Is there anything else I need to take care of?
People often forget about deducting points paid to lower their mortgage rates. For example, if you paid $3,000 in points when you refinanced your home two years ago, you were probably able to deduct only $100 per year (because points paid in a refinance transaction must be amortized). If that's the case, you may have $2,800 in undeducted points that you may be able to deduct this year. See current mortgage rates here.
For more on how your home and mortgage may impact your taxes, be sure to read "10 critical questions for homeowners at tax time."