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Homeowner excited by relocation
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Home sales took a hit in 2023. According to the National Association of Realtors, the annual pace of 2023’s existing home sales—totaling 4.09 million—was the lowest number recorded since 1995, when it was 3.85 million. Experts cite many potential reasons, including post-pandemic buyer burnout, rising mortgage rates, and low inventory.
However, there was some good news for sellers: the median sales price in 2023 hit a historical high of $389,800, up 1% from 2022.
The mix of news means that homeowners were grappling with volatility in home sales in 2023. That may translate to confusion at tax time. Here’s what you need to know.
Not All Gain Is Taxable
Some taxpayers believe that any profit on the sale of a home is taxable, but that’s not true. Under section 121 of the tax code, taxpayers are allowed an exclusion of up to $250,000, or $500,000 for married taxpayers filed jointly, on the gain from the sale of a main home. That exclusion is available to all qualifying taxpayers—no matter your age—who have owned and lived in their home for two of the five years before the sale. Those tests are sometimes called the ownership and residency tests—you must meet both to claim the exclusion.
Main Home
The exclusion applies to the sale of your main home. For federal income tax purposes, you only have one main home at a time. If you have more than one home, your main home is typically the one you live in most of the time.
You may also consider some other factors when thinking about your main home:
- Where do you receive your mail?
- Where do you vote?
- Where did you get your driver’s license?
- Where do you file your federal and state tax returns?
- Where do you work?
- Where do you go to church?
Generally, the most common answer to those questions is indicative of your main home.
Importantly, your house doesn’t have to be a traditional single-family home—a condominium, a cooperative apartment, a mobile home, or a houseboat could all qualify as your main home.
While you may only have one main home at a time, you may have more than one during your lifetime. There is no longer a one-time exemption—that was the old rule, but it changed in 1997. That means today, you can use the exclusion multiple times so long as you meet the criteria each time.
Additionally, there’s no rule that says what you have to do with the proceeds. Despite a popular rumor—attributable to that old rule—you don’t have to invest in another home or investment to qualify for the exclusion. You could pocket the cash or splurge on a new car—the result is the same for federal income tax purposes.
Qualifying Criteria
You can meet the residency and ownership tests during different periods—like year one and year three—so long as you must meet both tests during the five-year period. It doesn’t have to be a continuous block of time—all that is required is a total of 24 months (730 days) of use during the five-year period.
Only one spouse must meet the ownership requirement for a married couple filing jointly. However, each spouse must meet the residency requirement to get the full exclusion.
Reporting Requirements
An exclusion typically means you don’t have to include the amount in your income. However, if you receive an informational income-reporting document, like Form 1099-S, you must report the sale even if the gain is excludable. Additionally, you must report the sale if you can’t exclude all of your capital gains from income.
If it’s a reportable sale, you’ll file Schedule D and Form 8949 with your Form 1040. Don’t worry—you can back out the exclusion on the forms.
Figuring Your Gain
Your starting point for figuring your capital gain is your basis. Basis is the price you originally paid for the house plus any significant improvements. For example, if you buy a house for $200,000, that’s your cost basis. If you make a capital improvement—a change that adds permanent value to your home, like an addition—it will increase your basis. If you make a change like that, keep good records to support the increase.
(For inherited property, your basis is the fair market value on the date of the owner’s death. For gifted property, your basis is the same as the original owner’s—it’s sometimes called carry-over basis.)
When figuring additions to basis, you can include repair work if it is done as part of an extensive remodeling or restoration job. For example, replacing broken windowpanes is a repair, but replacing the same window as part of replacing all the windows in your home is considered an improvement.
Work you can’t include in your basis includes necessary repairs or maintenance to keep your home in good condition, like painting (interior or exterior), fixing leaks, filling holes or cracks, or replacing broken hardware. You also can’t include the costs of any improvements that are no longer part of your home, like flooring that you installed but later replaced or improvements with a life expectancy of less than a year.
One additional note: When figuring your basis, if you included the cost of any energy-related improvements (such as a solar energy system) and you received any tax credits or subsidies related to those improvements, you must subtract those credits or subsidies from your total basis.
A Look At The Math
Let’s look at an example. Let’s assume that you bought a house for $200,000 and added a mother-in-law suite at a cost of $60,000. Your basis is now $260,000, or $200,000 (original purchase price) plus $60,000 (addition).
When you sell your home, your gain is the difference between the selling price and your basis. So, continuing the example, if you sold your house for $700,000, and your basis was $260,000, your gain is $440,000, or $700,000 minus $260,000.
The exclusion is up to $250,000 for single taxpayers or $500,000 for married taxpayers. If you are married, you will subtract $500,000 from your gain—in our example, the gain was $440,000. In that example, since the exclusion is more than your gain, there is no capital gains tax on the sale. If you were single, however, you’d subtract $250,000 from your gain—again, the gain in our example is $440,000. In that case, your gain is $190,000 more than your exclusion, so capital gains tax would apply.
Capital Gains Tax
The difference between your selling price and your basis is your gain, not the actual tax owed.
If you owned your home for one year or less and then sold it, your capital gain is short-term, and you’ll be taxed at your ordinary income tax rate. The rates and brackets for 2023—the return you’re filing now—are here. (You can find the 2024 tax rates and brackets here.)
However, if you have owned your home for over a year, your capital gain above the exclusion is long-term. For 2023, the long-term capital gains rates for most capital assets are 0%, 15%, or 20%, depending on your filing status and income.
Losses
If your basis is more than the selling price, you have a loss. So let’s assume, for example, that your basis was $260,000, and you sold your home for $100,000, leaving you with a $160,000 loss. While it’s a hit to your wallet, there is no tax impact—you can’t claim a loss on the sale of a personal residence.
Disqualification
Your home sale isn’t eligible for the exclusion—even if it’s your main home—if you acquired the property through a like-kind exchange (sometimes called 1031 exchange) during the past five years or if you are subject to expatriate tax.
Suspension Of Time
The exclusion rules are very specific, including the ownership and residency rules. However, if you or your spouse are on qualified official extended duty in the Uniformed Services, Foreign Service, or intelligence community, you can suspend the five-year test period for up to 10 years. You’re considered to be on qualified official extended duty if, for more than 90 days or an indefinite period, you are at a duty station at least 50 miles from your main home or residing under orders in government housing.
Partial Gain
If you don’t meet the ownership and residency tests, you may still qualify for a partial exclusion of gain. For example, you can meet the requirements for a partial exclusion if the main reason for your home sale was a change in workplace location, a health issue, or an unforeseeable event. Unforeseeable events can include a condemnation of your home, the death of someone in the home, multiple births from the same pregnancy, or a change in work status, such as unemployment, that results in financial hardship.
Exceptions
Since this is tax law, a few more exceptions may apply. For example, you would have no reportable gain or loss if you transferred your home or share of a jointly owned home to a spouse or ex-spouse as part of a divorce settlement. This exception does not apply if your spouse or ex-spouse is a nonresident alien.
If you become physically or mentally unable to care for yourself and use the residence as your principal residence for at least 12 months of the five years before the sale or exchange, any time you spend living in a care facility, like a nursing home, counts toward your residence requirement. That’s true so long as the facility has a license from a state or other political entity to care for you.
If you have a situation that doesn’t fit neatly with the rules, check IRS Publication 523 or consult your tax professional for more information.
Home Sales In 2024
So what about this year? It looks to be an improvement over 2023. The National Association of Realtors predicts 4.71 million existing-home sales in 2024, up 13.5% from 2023—some of the most active markets will be in Austin, Dallas-Fort Worth, Nashville, Philadelphia, and Washington, D.C. However, annual median home prices are expected to remain largely unchanged.
That could mean that many homeowners will see a profit in 2024. Assuming no changes from Congress, the same capital gains exclusions and rules will apply in 2024.
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