Ask Liz Weston

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Home Sale Tax

Q&A: Capital gains taxes on a house sale

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Dear Liz: We purchased our home for $220,000 in 1986 and are selling it for $1 million. We own it free and clear. The proceeds from the sale will be going toward the purchase of another property, to be owner-occupied, for $1.4 million. We will be coming in with additional cash to cover the difference. Our question is whether we will be subject to capital gains tax on the proceeds from the sale of our current home.

Answer: Most likely the answer is yes.

Each owner can exclude up to $250,000 of gain from the sale of their primary residence as long as they owned and lived in the home at least two of the previous five years. Whether they have a mortgage and what they do with the money afterward isn’t relevant for calculating this tax.

You may be able to reduce the capital gains tax bill if you paid for home improvements over the years and kept good records. According to the IRS, improvements or additions that “add to the value of your home, prolong its useful life, or adapt it to new uses” can be added to your tax basis, which is usually the amount you spent to buy the home. IRS Publication 523, Selling Your Home, has details.

Q&A: IRS and selling a home

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Dear Liz: How does the IRS know you sold your house? If you sell and buy another home, must you report it? Most folks I know sell, then buy a more expensive house. Seems like lots of moving parts for the parties, including the IRS, to have to track.

Answer: Not really. The title company or attorney handling the closing on a property sale typically generates a Form 1099 with the sales price of the home. The seller gets a copy and so does the IRS. Sellers who “forget” to account for the proceeds on their tax returns will soon get a reminder from the IRS, which typically just tacks the sale amount onto the sellers’ income and demands its cut, along with penalties and interest.

Q&A: Taxes on home sales

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Dear Liz: I thought that if you occupied a home as your principal residence for two of the last five years that you could exclude capital gains of up to $250,000 if single or $500,000 if married. Someone recently told me that this has been changed to a pro-rata calculation.

Answer: That someone was wrong. The pro-rata calculation applies to people who have not owned and lived in the home for at least two years but who meet other criteria for a partial exemption. The percentage of gains you can exclude from your income is based on the percentage of the two-year requirement you fulfilled.

Let’s say you had to sell the home after a year because your place of employment changed to one at least 50 miles away. You could exclude capital gains of up to 50% of the exemption amount — $125,000 if single or $250,000 if married — from your income.

Q&A: Selling a rental property? Here are the tax consequences

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Dear Liz: My siblings and I are considering selling a triplex. It was bequeathed to us by our mother when she died in 2007. There is no mortgage and it is fully occupied. If we sell, my wife and I (both over 50) would get roughly $200,000, and we’d like to minimize the tax impact. We own our home free and clear and have no debt. We’d like to use this windfall to help our son buy a home. We’d also give our daughter a cash gift. We have no interest in buying another investment property using a 1031 exchange. Any suggestions to minimize our tax bill given our circumstances?

Answer: Talk to a tax pro, because selling a rental property is more complicated than selling your personal home.

You’re not eligible for the $250,000-per-person home sale profit exclusion, and in addition to paying capital gains tax you also face a depreciation recapture tax of 25%. (Depreciation is the amount of wear-and-tear you wrote off during your ownership of the property; the IRS requires you to repay that tax break when you sell.)

A big capital gain could affect other areas of your finances, such as Medicare premiums, and the pro can help you plan for that as well.

A 1031 exchange would allow you to defer taxes on a rental property by buying a similar replacement property.

Another solution would be to hang on to the property, continue to enjoy the rental income and bequeath your portion of it to your children when you die. Your portion will receive a favorable step-up in tax basis so that your heirs won’t owe taxes on the capital gains that occurred during your ownership. They also won’t face the tax on depreciation recapture you would otherwise owe.

But that obviously isn’t a good solution if you no longer want to be a landlord or want the cash instead. In that case, the tax pro can help you properly account for selling costs, legal fees and improvement expenses that could reduce the tax hit and may be able to suggest other ways to manage your tax bill.

Q&A: Offsetting home sale taxes

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Dear Liz: We recently sold a house and have taxes to pay on the proceeds. I’m wondering if we can take some of the proceeds and put them into 401(k) accounts, and pay taxes on them later?

Answer: You can’t do this directly, since 401(k) contributions are made through payroll deductions. If you haven’t already maxed out your retirement contributions, however, you could increase your contribution rate to offset some of the taxable income you created when you sold the house. Some employers allow you to contribute 100% of your pay, up to the IRS contribution limits. In 2022, the limit is $20,500 for people under 50 and $27,000 for people 50 and older.

You also could contribute $6,000 to an IRA (or $7,000 if you’re 50 and older), but your ability to deduct the contribution depends on your income if you’re covered by a workplace plan such as a 401(k). If you’re married filing jointly and have a workplace plan, your ability to deduct an IRA contribution phases out with modified adjusted gross income of $109,000 to $129,000.

Remember that you can exempt up to $250,000 of home sale profits (or $500,000 for a couple) if you owned and lived in the property as your primary residence for at least two of the last five years. You also may be able to reduce the taxable gain if you kept good records of qualifying home improvements. For more information, see IRS Publication 523, Selling Your Home.

Q&A: You need to satisfy this key requirement to get an IRS home sale tax exemption

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Dear Liz: I was given a condominium, which I’m renting out while I live overseas, traveling from country to country. I understand that when I sell the condo, I can exclude up to $250,000 of home sale profits if the property is my “primary residence” for at least two of the last five years. But how is primary residence established? I have heard that the IRS looks at the address on your tax returns, on your voting registration and on file with the Department of Motor Vehicles. I list the condo’s address for voter registration but with the IRS and DMV, I use my mail forwarding address. Will that keep me from establishing the condo as my primary residence?

Answer: What’s keeping you from establishing the condo as your primary residence is the fact that it’s not your primary residence. Someone else is living there and paying you rent.

If you want to take advantage of the home sales profit exemption, you need to actually occupy the home. You’re allowed “short, temporary absences” but not the vagabond life.