In many areas of the U.S., buying a home has been a great financial move. Stocks may go up or down but home prices have gone steadily through the roof, during the last decade.
Now for the really good news. When it’s time to sell your home (whether you intend to move up the housing ladder or downsize), you are entitled to a unique tax break: tax-free gains. Married couples filing jointly can exclude up to $500,000 worth of gains on home sales. For single filers, the limit is $250,000.
These exclusions are not the once-in-a-lifetime deals that previously existed. You can use the exclusion as often as every two years, no matter what your age. The requirements are that you must have owned and occupied your home as a principal residence for at least two out of the five years prior to the sale.
Suppose, for example, you’re married and you bought a house many years ago for $200,000. You’re going to move in retirement and you sell the house for $850,000. Do you have a $650,000 capital gain? Not really.
First, you need to add to your basis all the capital improvements you’ve made over the years. Say you have spent a total of $100,000 on a new roof, a remodeled kitchen, a swimming pool, and a central air-conditioning. Now your basis is $300,000, not $200,000, and your total gain is $550,000.
Then your $500,000 exclusion cuts your taxable gain to $50,000. At a 15 percent rate, you’d owe only $7,500 to the IRS, on an $850,000 home sale.
Other tactics to consider:
- Owners of second homes can sell their primary residence, as described above, and move into what had been a vacation home. After living there for two years you can sell this home, too, and claim an exclusion for up to $500,000 worth of gains.
- Owners of investment property can exchange that property, tax-free, for another commercial property, under Section 1031 of the tax code. To do so, you could sell your old property and have an unrelated “accommodator” hold the proceeds in an escrow account. Then you can use those proceeds to buy a home that you rent to tenants.
After a year or two, you can move into the home you’ve been renting. Under current law, converting the house to residential use won’t trigger the deferred gains.
Once you’ve lived in this house as a principal residence for at least two years, you can sell it. Again, up to $500,000 worth of appreciation can be tax-free, including unrealized gains from your original investment property.
