Tax Consequences of Selling your Home

There are certain recurring conversations we seem to have with almost every client. The tax consequences of selling a home is usually at the top of that list!

Owning and selling real estate can have very real tax implications. In order to promote home ownership and real estate investment, Congress has structured the tax code so there are real benefits to owning real estate. This blog is going to be a shallow dive into some of those benefits, with the understanding that we are not professional tax advisors or accountants. Although we believe this information to be accurate, we do not guarantee it, and strongly encourage you to use this post to start a conversation with your tax professional.

In super simple terms, the IRS groups real estate into two categories: primary residences, and investment properties. The tax rules are different for each of those two categories.

When you sell your primary residence, you may claim a capital gains tax exemption of up to $250,000. That tax exemption climbs to $500,000 for a married couple. This exemption is for the profit you make on the sale, or the difference between your original purchase price (the basis) and final sale price. Note that you can reduce that profit by subtracting the cost of property improvements you’ve made over the years and the cost of selling the home. In order to claim this exemption, you must have lived in the home two out of the last five years. 

Imagine you purchased a home in 2005 for $200,000. If you sold that home today for $550,000, your gain would be $350,000 (minus allowable expenses such as property improvements and costs associated with selling the home, but we’ll ignore that for simplicity). Since you can claim up to $250k in capital gains on a primary residence, you’d either owe taxes on just $50,000 as an individual, or would have no capital gains taxes on the sale if you were a married couple. Note - this doesn’t mean you would owe $50,000 in taxes, but rather you would be taxed on the $50,000 profit at the long term capital gains rate, which is probably lower than your income tax rate.

That’s a huge incentive to own real estate, and makes real estate one of the very few ways you can make a large profit and pay no taxes. It is also very important to note that you are under no obligation to use that money to purchase another home. Do whatever you want to with it— it's tax-free income!

The rules are very different for investment properties. Let's use that same home that you purchased in 2005 for $200,000, and then sold today for $550,000, but you used it as a rental rather than a primary residence. The IRS will absolutely tax your entire profit at the long-term capital gains rate. Most savvy investors will have worked with their accountant to depreciate the property, and the IRS will also want to recapture that depreciation, yet another source of profit of the IRS wants to tax. Expect a substantial tax bill!

There are only three ways out of this scenario. The first is to sell the property and pay the taxes. The second is to die, and your heirs will inherit at the property at a stepped-up basis, or the amount it was worth at the time of the original owner’s death. This means your heirs are likely to avoid paying taxes on it. The third strategy is called a 1031 exchange.

Most savvy real estate investors use 1031 exchanges to defer tax liability. Instead of selling an investment property, the investor will hire a 1031 exchange intermediary to “exchange” the property. To the general public, it looks like they are selling one rental to buy another rental, but to the IRS, they are exchanging the two and simply moving the tax burden from the first property to the second property. You effectively kick the tax can down the road! This process can be repeated indefinitely, and one property can be exchanged for many, many for one, etc.

When we work with homeowners, it’s fun to share the good news - you’re likely to pocket all of the profit from the sale of the home you’ve lived in for at least the past two years and not pay a dime in taxes!

When we help rental property owners sell properties, the conversation is much more nuanced. Since we have a fiduciary responsibility to our clients, we encourage them to visit with their accountant to discuss the tax implications of selling the rental. We want to make sure our clients are making a fully informed decision. They should be clear whether it makes more sense for them to sell outright and take the tax hit, or do a 1031 exchange into a different rental. Our goal is no surprises come tax time!

If you’d like a confidential conversation about real estate, give us a call. 

Jeffrey