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home sale exclusion

Q&A: Selling a house? Don’t confuse the tax rules

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Dear Liz: We read your recent column about capital gains and home sales. Our understanding is that if you sell and then buy a property of equal or greater value within the 180-day window, the basis for tax purposes is the purchase price, plus the $500,000 exemption, plus the improvements to the property, minus the depreciation, whatever that number comes to, and then the profit above that has to be reinvested or it is subject to capital gains. We talked to our CPA about this and he referred us to a site that specializes in 1031 exchanges.

Answer: You’ve mashed together two different sets of tax laws.

Only the sale of your primary residence will qualify for the home sale exemption, which for a married couple can exempt as much as $500,000 of home sale profits from taxation. You must have owned and lived in the home at least two of the previous five years.

Meanwhile, 1031 exchanges allow you to defer capital gains on investment property, such as commercial or rental real estate, as long as you purchase a similar property within 180 days (and follow a bunch of other rules). The replacement property doesn’t have to be more expensive, but if it’s less expensive or has a smaller mortgage than the property you sell, you could owe capital gains taxes on the difference.

It is possible to use both tax laws on the same property, but not simultaneously.

In the past, you could do a 1031 exchange and then convert the rental property into a primary residence to claim the home sale exemption after two years. Current tax law requires waiting at least five years after a 1031 exchange before a home sale exemption can be taken.

You can turn your primary residence into a rental and after two years do a 1031 exchange, but you would be deferring capital gains, while the home sale exemption allows you to avoid them on up to $500,000 of home sale profits.

Q&A: Time to move, but what about the capital gains?

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Dear Liz: My husband and I built a home on a hillside over 30 years ago in a desirable neighborhood with a beautiful view. We thought it would be our retirement home, but life had different plans. Now seniors, dealing with age, stairs and progressive health issues, we have been advised that selling and moving to a senior assisted living facility is the best option for us before we are forced by circumstances to move. And, we were told, it would be less expensive than having full-time, in-home care.

We are concerned that capital gains would take a big chunk out of the sales proceeds from our home, and that’s money we need to pay for assisted living. Can we use the purchase price of the vacant lot against the capital gains? Can we use the bank loan for building the house against the capital gains? Can we use the cost of an apartment or condo in an assisted living residence against the capital gains? What other things can be used against capital gains other than general home improvements?

Answer: A large gain wouldn’t just reduce the amount of money you have for the next phase of your life. It also could increase your Medicare premiums for a year, thanks to the income-related adjustment amount or IRMAA.

You’ll determine your potentially taxable capital gains by deducting your tax basis from your home sales proceeds. Your basis includes the purchase price of the lot and the cost of construction, plus any qualifying home improvements you’ve made over the years.

The two of you can shelter up to $500,000 of home sales profits from capital gains taxes. Capital gains also can be reduced if you have capital losses — in other words, if you’ve sold stocks or other assets for a loss.

What you do with money doesn’t affect the capital gains taxes you pay. Decades ago, you could defer capital gains by buying another home of equal or greater value, but that’s no longer the case.

You may have some alternatives to lessen the impact of the gains, such as an installment sale where the buyer pays over time. Another option would be renting out rather than selling your home.

A tax pro can provide guidance.

Q&A: Losing a home in a fire, then being hit with a ‘casualty gain’

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Dear Liz: My house was burned down in the Palisades fire. I lived in the house for 25 years and lost everything. I thought there may be a silver lining with tax deductions. Much to my surprise, I am supposed to use the purchase price from 25 years ago as my adjusted cost basis. The insurance settlement is not going to be enough to rebuild but is more than my cost basis. I will end up with “casualty gain” instead. Is this possible?

Answer: After losing your home and finding out you were underinsured, the news that you might have a taxable gain must have been a gut punch.

The IRS calls it an “involuntary conversion” when your property is destroyed and you receive insurance proceeds. If the insurance payment exceeds your tax basis in the property, that’s known as a casualty gain.

You can defer tax on this gain if you use the insurance payout to rebuild or buy a replacement property, says Mark Luscombe, a principal analyst with Wolters Kluwer Tax & Accounting. Normally you’d have two years to use the insurance proceeds, but in a federally declared disaster such as the Los Angeles fires, the deadline is extended to four years.

The IRS may be willing to further extend the deadline under some circumstances, such as contractor delays, Luscombe says. But don’t count on an extension if you’re simply unable to find a replacement property.

If you do purchase a new home elsewhere, any gain from the sale of the lot where your previous home stood also would have to be reinvested in the new home to avoid a current tax on the gain, Luscombe says.

However, the home sale tax exclusion also applies to involuntary conversions. The exclusion allows you to shelter up to $250,000 of gains ($500,000 if married filing jointly) on a sale or involuntary conversion, as long as you’ve owned and lived in the property as your primary residence for two of the last five years. So you could exclude that amount of gain and defer the rest if you rebuild or find a replacement property, Luscombe says.

This is complicated territory, so please make sure you hire a tax pro to guide you.

Q&A: Sale of last home can trigger capital gains taxes

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Dear Liz: I am 74 and my husband is 68. We have decided to sell our last home and rent. Do we have to pay taxes, specifically capital gains, on the sale of our last home or are we able to keep the sale proceeds in full?

Answer: Any home sale is potentially subject to capital gains taxes. Your gain is determined by subtracting your tax basis — the price you paid for the home, plus any qualifying improvements — from the net sales proceeds. If you owned and lived in the home as your primary residence for at least two of the previous five years, you can exclude up to $250,000 (or $500,000 if married filing jointly) of home sale profits. You would owe taxes on the capital gains that exceed those limits.

A large-enough capital gain could affect how much you pay for Medicare. The “income-related adjustment amount,” or IRMAA, is based on your income two years prior, so a big gain in 2025 could increase your premiums in 2027.

You’d be smart to talk to a tax pro before you sell so you understand the ramifications.

Q&A: More on those lost home improvement receipts

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Dear Liz: You recently answered a question from a home seller who had lost documentation about improvements. The improvements most likely required building permits, which would have indicated the scope of improvements and, possibly, the cost as well. The local building department will have copies of those permits on file, and they can be obtained at a modest cost.

Answer: Thank you. The original letter writer had lost their documents in a house fire, a circumstance now shared by far too many in the Los Angeles area, thanks to the recent wildfires.

To recap, the value of qualifying home improvements can reduce the taxable gain when a house is sold. But if audited, sellers probably would need some kind of proof the work was done.

Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting, suggested asking any contractors that were hired to provide verification of the projects and to check with the property tax assessor to see if the improvements were reflected in the home’s assessment. Photos of the home reflecting the improvements could also help in an audit, Luscombe says.

Q&A: Elderly and cash-strapped, a couple consider a proposal to sell their home to neighbors

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Dear Liz: I’m 80 years old and my wife is 76. Our only retirement income is Social Security, and we have less than $50,000 in savings. We have about $600,000 equity in our house, which we bought in 1971. We presently have property taxes deferred, at 6% interest. The house is in disrepair.

We have two neighbors who are willing to buy the house after one or both of us die. The neighbors are willing to postpone occupancy and contribute to mutually agreed-upon home repair costs, which will be deducted from the selling price. Details will all be in the contract. These payments will greatly improve our lives. What could go wrong?

Answer: Well, a lot, which is why you need an experienced real estate attorney to represent you if you go ahead.

It’s not clear from your letter if your neighbors are locking in a sale price now, which would mean you and your wife (or your estates) would give up future price appreciation. Are the payments simply contributions toward the repairs or are they purchase payments? Also, what happens if you need to tap your equity to pay for long-term care? If you or your neighbors want out of the deal, would that be possible? Those and many more details need to be thought through.

But your situation, and your proposed solution, are not that unusual, says Los Angeles estate planning attorney Burton Mitchell. Many older people with highly appreciated properties don’t want to sell their homes and trigger taxable gains in excess of the $250,000-per-owner home sale exclusion.

Another alternative to consider is a reverse mortgage, which could allow you to tap your equity while you remain in the home. You wouldn’t have to make payments on this loan, and the balance would not be due until you and your wife die, sell the home or move out.