For most people, their home is their biggest asset. A law change in 1997 made it possible for most people to sell their home tax free. However, a law change in 2008 took away a favorite loophole for people who owned multiple homes or rental properties. While most home sales are relatively straightforward, you should pay close attention if you own multiple homes or have unique circumstances.
- General rule when selling your personal residence – If you have lived in your house for at least two of the previous five years and the house is used as your primary residence, you can exclude up to $250,000 of the gain when you sell the house if you are single and up to $500,000 if you are married and file a joint tax return. Any gain above $250,000/$500,000 threshold will be taxed at the regular capital gains rate. You can use this exclusion any number of times over your lifetime as long as you occupy the house as your principal residence for at least two years and you haven’t used the exclusion in the past two years, but read below to understand how the 2008 law change put some restrictions on those who hop among multiple properties and use the exclusion.
- If you claimed a home office deduction – If you claimed a home office deduction on your tax return in prior years, the home sale exclusion rules still apply. However, during the years you claimed the home office deduction, you should have claimed depreciation deductions for the portion of your house used as your home office. When you sell the house, you have to pay tax on the depreciation previously deducted (this is known as “depreciation recapture”). Even if you didn’t claim the depreciation in the years that you were supposed to, the IRS will still make you recapture that depreciation and pay the tax on it. Depreciation recapture is taxed at a rate of 25%.
- If your convert your home to a rental property – If you have lived in your house as a primary residence for at least two years, you can convert the property to a rental property and rent it out for the next three years and then sell it while utilizing the $250,000/$500,000 home sale exclusion. You will only pay the tax on the depreciation deducted in years 3 through 5. This is a nice way to shelter the capital gain on the sale of the property while collecting rental income for a few years.
2008 law change – Closing the loophole
The law change in 2008 affects people who own vacation homes or rental properties. The old strategy was to sell your personal residence and then move into your rental property or vacation home and make that property your personal residence for two years, sell that property and claim the home sale exclusion again.
The new law dictates that the years of use after January 1, 2009 must be divided between qualified use and non-qualified use. In essence, if the property was used as a vacation home or rental property before you converted it to your primary residence, the vacation/rental years after January 1, 2009 are considered non-qualified years and the non-qualified percentage of the gain will not be eligible for the exclusion.
Example: You purchase a rental property January 1, 2009 and rent it out until December 31, 2013. On January 1, 2014 you move into the house and make it your personal residence until December 31, 2015 and you sell the property in 2016.
- Old law – The entire gain would be able to be sheltered by the exclusion amount and you would only pay tax on the depreciation deducted when the home was a rental property between 2009 and 2013.
- New law – The five years that the property was a rental (2009- 2013) would be considered non-qualified use. Therefore 71% (5 years of non-qualified use / 7 years of total ownership) of the gain on the sale would not be eligible for the exclusion and you would still have to pay tax on the depreciation deducted between 2009 and 2013. The result would be the same if the property was used as a vacation home and not as rental property.
Non-qualified use does not include years of use before January 1, 2009 or for any years after the home was used as a principal residence. If you use a home as your principal residence for two years and then rent it out for three years, you can still use the exclusion on 100% of the gain from the sale. You would just have to pay tax on the depreciation deducted in years 3 through 5. Non-qualified use does not included periods when an individual is away on qualified official extended duty (up to 10 years) or for temporary absences due to health or employment (up to two years).
Below are some other situations that may arise when selling your residence:
- 1031 exchanges – Personal residences do not qualify for a 1031 tax-deferred exchange. A vacation home may qualify if it has been rented out at fair market value and you can show that it was primarily used as a rental property and not merely a second home that was occasionally rented out. If you acquire a rental property in a 1031 exchange and you wish to convert it to your primary residence, you must hold the property for at least five years after the exchange while using it as your primary residence for two of those five years if you wish to use the home sale exclusion when you sell it. However, you still need to calculate the years of non-qualified use after January 1, 2009.
- You haven’t lived in your primary residence for two of the last five years when you sell – You still may be able to claim a reduced exclusion if the sale is due to change of employment of at least 50 miles away, health reasons or unforeseen circumstances including a natural disaster, unemployment or divorce.
- You get married and you move into your spouse’s house – Married couples can excluded up to $500,000 of the gain if they file jointly and at least one of the spouses used the house as a primary residence for any two of the preceding five years.
- You qualify for the exclusion but your gain is more than $250,000/$500,000 – In this scenario, the amount of gain over the exclusion will be taxed at the long-term capital gain rate of either 15% or 20% (depending on how much other income you have) plus your state tax rate for long-term capital gains.
- You sell a partial interest in your house – The exclusion applies if you sell less than 100% of your primary residence, and if you sell the remaining interest in a subsequent year, you can use any of the remaining exclusion if there is any available.
Most home sales will qualify for the full exclusion, but care needs to be taken if you own multiple properties. After the sale is too late to plan, so make sure you speak to a qualified CPA with experience in real estate taxation before you sell to understand the tax consequences of selling your property.
A growing number of companies are helping their employees pay off their student loans as a means to attract and retain talent. Currently, such assistance is considered a taxable fringe benefit to employees. There is currently a bill in Congress that would allow student loan payments made by an employer to be tax-free to the employee. I am not sure if this will become a law anytime soon, but it will provide much needed relief to college graduates burdened by student-loan debt.