Q&A: How to sort out the taxes when you sell your house

Dear Liz: I am trying to understand the capital gains tax exemption as it applies to the sale of a house. If I have no mortgage and I sell my house before I have lived in it for two of the previous five years that are now required for the exemption, is it based on the total selling price of the house or on the amount over what I paid for it? And what is the tax rate based on?

Answer: The home sale exemption can shelter from taxes up to $250,000 per owner ($500,000 for a couple) of capital gains from a home sale. If you don’t live in the home for at least two of the previous five years, you typically can’t use the exemption unless the sale was because of a change in employment, health problems that require you to move or an unforeseen circumstance that forced the sale.

The rules on these exceptions can get pretty tricky, so you’d need to discuss your situation with a tax pro. If you qualify, the amount of the exemption usually would be proportionate to the percentage of the two years that you actually lived in the home. If you sold after one year, for example, you might exempt up to $125,000 per owner.

Whether you have a mortgage does not affect the capital gains calculation. What matters is the difference between the price you get when you sell the house and the price you paid when you bought it.

From the sale price, you get to subtract any selling costs such as real estate commissions. From the purchase price, you can add in certain costs, such as home improvement expenses. What results after these adjustments is your capital gain for tax purposes.

If you have capital gains in excess of the exemption, you would pay long-term capital gains rates on that profit. Long-term capital gains are typically taxed at a 15% federal rate, although the highest-income taxpayers (those in the 39.6% bracket) may pay 20% and the lowest-income taxpayers (those in the 10% and 15% brackets, including taxable capital gains) pay a 0% rate.

States typically have additional taxes.

Q&A: Capital gains taxes explained

Dear Liz: Do I understand correctly that I must live in a house for two years before selling it to avoid paying capital gains tax, regardless of how much I may profit from the sale?

Answer: You do not. You must live in a home for two of the previous five years to exempt up to $250,000 of home sale profits. (Married couples can exempt up to $500,000.) After that, you’ll pay capital gains taxes on any remaining profit.

Even if you didn’t last the full two years, you may be able to claim a partial exemption if you meet certain criteria, such as having a change in employment, a health condition or other “unforeseen circumstance” that required you to move out.

Q&A: Capital gains tax on home sale profit

Dear Liz: I recently sold a home and am trying to escape the dreaded capital gains tax. I’ve done everything I can to reduce my overall tax bill, including maxing out my retirement contributions. I don’t want to buy a more expensive home to escape the gains tax. Any thoughts?

Answer: Buying a more expensive home wouldn’t change what you owe on your previous home. The days when you could roll gains from one home purchase into another are long gone.

These days you’re allowed to exclude up to $250,000 in home sale profit from your income (the limit is per person, so a couple can shelter $500,000). In other words, that amount is tax free, as long as you lived in the home for at least two of the previous five years. Beyond that your profit is subject to capital gains taxes. The top federal capital gains rate is 20%, plus a 3.8% investment surtax if your income is more than $200,000 for singles or $250,000 for married couples.

Here’s where good record-keeping may help. While generally you’re not allowed to deduct repair and maintenance costs from that profit, you can use home improvement expenditures to reduce the tax you owe. Home improvements are added to your cost basis — essentially what you paid for the property, including settlement fees and closing costs, and that’s what is deducted from your net sales price to determine your profit.

You’ll need receipts plus credit card or bank statements to prove what you paid. Improvements must “add to the value of your home, prolong its useful life, or adapt it to new uses,” according to IRS Publication 523, Selling Your Home. Examples of improvements include additions, remodels, landscaping and new systems, such as new heating or air conditioning systems. You can include repairs that are part of a larger remodeling job, but you can’t include improvements you later take out (such as the cost of a first kitchen remodel after you do a second one).

Q&A: Income tax vs. capital gains tax

Dear Liz: I was wondering about the disabled vet who wanted to sell his home, which had increased in value by about $1 million. You mentioned that “[S]ingle people with incomes over $415,050 in 2016 are subject to the 39.6% marginal tax rate. Most people pay capital gains tax at a 15% rate, but those in the top bracket face a 20% rate.” Would he have to pay federal income tax on the non-exempt portion of the equity as well as paying 20% capital gains on the non-exempt portion?

Answer:
You may pay income tax or capital gains tax on a source of income, not both. If an investment has been held less than a year, the gain is considered short term and subject to income tax. Investments held more than a year are considered long-term and qualify for capital gains treatment.

When you’re selling your primary residence, the first $250,000 in profit is typically exempt from tax. The rest of the gain would be taxed as a capital gain.

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Q&A: Capital gains tax on mutual funds

Dear Liz: My mother, who is approaching 100 and in good health, has a significant mutual fund holding. It is mostly made up of capital gains. She does not need this fund for her daily living expenses. The question she has: Are the taxes on disposition the same before or after she dies? I am thinking of things like the capital gains tax exemption (never used) as well as inheritance taxes.

Answer: The capital gains tax exemption applies to the sale of a primary residence — a home, not a mutual fund. If your mother sold the fund today, she would owe capital gains tax on the difference between the sale price and her “cost basis.” Her cost basis is what she paid for the fund originally plus any reinvested dividends. The top federal capital gains tax rate is 20%, although most taxpayers pay a 15% rate.

If her objective is to get the maximum amount to her heirs and minimize the tax bill, she should bequeath this investment to them at her death. Then the mutual fund will get a “step up” in tax basis to the current market value. When the heirs sell the investment, they’ll only owe taxes on the appreciation that occurs after her death (if any).

You asked about inheritance taxes, but only a few states levy taxes on inheritors. Typically, it’s the estate that would pay the taxes, and only those above certain amounts. In 2016, the federal estate taxes exemption is $5.45 million

Q&A: Long-term capital gains tax

Dear Liz: I’m very confused about the long-term capital gains tax. Several years ago, I bought a house for $525,000 in Texas. I’ve been thinking about selling, and my real estate agent informed me that my home is now worth $1.5 million. I am a disabled veteran and have no tax liability because my income is tax-free. Since this is my primary residence, I know that the first $250,000 in gains is exempt from tax. What I just don’t understand is what my tax liability will be on the rest of the money.

Answer: If you sell this house, you’ll essentially go from the bottom tax bracket to the top. Single people with incomes over $415,050 in 2016 are subject to the 39.6% marginal tax rate.
Most people pay capital gains tax at a 15% rate, but those in the top bracket face a 20% rate.

Improvements you’ve made to the house and some other expenses, such as selling costs, can reduce the amount of gain that’s subject to tax.

This big windfall could have other effects on your taxes, so you’ll want to consult a tax professional before proceeding.