In
some cases it is legal to not owe or
pay taxes when you sell your primary residence. Here is how it works:
“Let’s
start from the very beginning, a very good place to start”.
The first issue is
to know the "basis" of your home. Your original cost basis is the
amount of money you paid for your home. But during the time period you owned
and lived in your home, the original cost basis can be adjusted up or down
dependent on things like capital improvements to the home, depreciation[1],
or damage that causes a reduction in value.
When you sell your home, you can
have a gain or a loss, but how the IRS views that gain or loss can vary. For
now think of it like buying a stock and holding onto it for a number of years
before selling it. And then, upon the sale you either made money or lost money.
To determine if you have a gain or a
loss, know that your basis is the beginning point for gain or loss calculation.
Then take into consideration the amount for which you sell the property.[2]
For the sake of this story let’s
assume the only thing affecting the value of your home is appreciation.
Therefore, the capital gain on your home sale is the difference between the
sale price and what you originally paid for the home. If you have owned and
lived in your home for many years, that capital gain may be a significant amount.
121 Exclusion: The IRS says in most
cases up to $250,000 in capital gains ($500,000 for a married couple) is exempt
or tax-free provided the home was your principal residence for two out of five
years prior to the sale.
Be aware, however, that this
exclusion does not apply to investment properties (rentals)[3],
second homes, when a home or a partial interest in a home has been gifted to
you, or for joint ownership with children, or real estate inheritances.
In the case of an inheritance, however,
there is another tax allowance and that is you are able to claim "stepped-up
basis". This means your basis for the inherited home is “stepped up” to
the market value of that home on the date you received it. The capital gain when
you sell it is then calculated using your stepped-up value vs. the original
basis, and this could save you thousands of dollars in taxes. Note that this is
also true of inherited stocks, bonds, ETF’s or mutual funds. Keep in mind we
are only focusing on capital gains tax here as other taxes may apply, but that
is an entirely different story!
Because tax code changes every year,
many taxpayers are unaware of how the step-up in basis works, and wind up gifting[4]
their home to their heirs or change to joint ownership with their heirs
assuming they are saving on estate, capital gains and inheritance taxes. But
doing this could present their heirs with a large tax liability upon sale.
There are also situations where the
step-up in basis is not straightforward, for instance when one spouse passes
away, and the home is held in joint tenancy with right of survivorship. In this
situation the surviving spouse receives a half-step-up in basis, based on the fifty-percent
of the home that the deceased spouse owned.
When “gifting” occurs there are many
considerations such as the gift tax implications (again a story for another
day) and the loss of stepped up basis. How you calculate the basis of gifted
property depends on whether there will be a gain or a loss.
For determining gain, the gifted basis
is the same as that of the original owner and this is known as “carryover”
basis. It is for this reason that planners suggest holding onto a highly appreciated
asset and bequeathing it instead of gifting it.
This choice could save your heirs thousands of tax dollars.
When a gifted asset loses or
depreciates in value to less than the donor’s original cost, the recipient’s
basis is the fair market value (FMV) of the asset at the time of the gift. So
say a donor paid $100 for some stocks that he or she then gifts and when the
gift occurs the shares are worth $50. By the time the recipient sells the shares
they are only worth $25. Here is how that loss would be calculated:
$50
(FMV at gifting) -$25 (sale price) = $25 loss
Using the same original donor basis
of $100, if the value of the asset had appreciated and was $200 when gifted but
dropped to $50 when the recipient sells it, you would calculate loss this way:
$100
(donor basis) - $50 (sale price) = $50 loss
While we suggest keeping in mind 121
exclusions, stepped-up basis and gifting vs. bequeathing when considering the
disposition of your home, or any asset, we realize that other factors may influence
your specific situation. Therefore, always make an informed decision. It is best
to consult with a professional before “winging it”.
[1]
Depreciation is a reduction
in the value of an asset over time, due typically to wear and tear and it is an
indication of how much of an asset’s value has been used up; in general this
applies only when the a tangible asset (in this case your home) has been used
for business or rental purposes.
[2]
Although the IRS may exempt or realize some or all of the
gain, you cannot take a loss on the sale of a primary residence.
[3]
Rental or other business properties, vacation homes, and part
rentals are subject to an entirely different set of rules and taxes, potentially
including a tax on “depreciation recapture”.
[4]
Gifting occurs when an asset is transferred to another while
the original owner is still alive; a bequest is when an asset is transferred to
someone else postmortem, and this is known as an inheritance.
