According to Federal Reserve Bank of St. Louis, the median selling price of homes in the first quarter of 2009 was $208,400. In the fourth quarter of 2021, the median home sale price was $423,600, which has more than doubled in 13 years. But that doesn’t tell the whole story.
Over the past few years, house prices in some places have risen much faster. According red finthe median home price in Los Angeles is up 14% from a year ago. Zillow reports that the typical home in Boise, Idaho, increased 20.6% in value over the same period. And according to the S&P CoreLogic Case-Shiller Indexhome prices in 2021 rose 32.6% in Phoenix, 30.8% in Tampa and 28.1% in Miami – in a single year.
If you bought your home in one of the top 20 metro areas some time ago, perhaps during the “Great Recession” or even 30 or 40 years ago, chances are your property has seen an increase significant in value. If you are about to sell, you can imagine that you could have a large capital gains tax bill to pay. And that capital gains tax could significantly reduce the funds you’ll have to pay for your next home, which has also increased in value significantly.
Here’s how capital gains tax currently works: Generally, if you buy a house and live there as your principal residence for two of the last five years, you can keep up to $250,000 of capital gains tax free of tax. If you’re married, you can keep up to $500,000 of capital gains tax-free.
How do you calculate your capital gains? According IRS Publication 523, “Selling your house”, add up the cost of buying the property, plus the cost of any physical improvements you have made over the years (such as replacing a roof, adding a room or a swimming pool), plus the cost of selling the property (such as the commission you will pay). Then subtract that number from the sale price of the house.
One of our readers asked how to calculate capital gains on the house they tore down in 1993. They rebuilt it for about $250,000 and a year later added a pool for $25,000. Their upgrades totaled $275,000. Assuming they paid $100,000 for the old house, the base (using very general numbers) would be $375,000.
Suppose the house sells today for $1 million. If they paid a 5% commission, or $50,000, they would add that amount to the base, bringing it to $425,000. They would subtract $425,000 from the sale price of $1 million and realize a capital gain of $575,000. They could keep $500,000 tax-free and would then be liable for long-term capital gains tax on the $75,000, regardless of their marginal tax rate.
(They may owe an additional 3.8% for the net tax on investment income. This tax may affect those with net investment income and adjusted gross income above certain thresholds. For 2021, the threshold was $250,000 of adjusted gross income for married couples filing jointly. They may also owe taxes to the state in which the home is located.)
Many owners have rented out their properties for a certain period of time during their years of ownership. This complicates the calculation of the capital gain, especially if you have suffered a depreciation and you must reimburse the federal government for this depreciation after the sale.
Another of our correspondents writes: “We are selling our townhouse this year, which we bought in 1996. We lived there for 17 years as our main residence. Then we rented it for eight years. There will be a substantial gain. How can we shelter this? »
The easiest would be to move back into the property for two years and use it as your primary residence. Then you would meet the standard of having lived there as your primary residence for two of the last five years, allowing you to keep up to $500,000 in tax-free profits. You may still have to recoup 25% of the depreciation you took on the property during those years, but you’ll house a significant portion (if not all) of the gains.
As you have rented the house for many years, you will need to ensure that you strictly adhere to the “two of the last five years” rules. Otherwise, you risk failing the test and not being entitled to benefit from the exclusion. IRS Publication 523 gives a number of examples of your eligibility and how the exclusion works.
As with anything from the IRS, the rules can be convoluted and confusing. If you have any questions, you may wish to consult a tax or financial advisor who has extensive experience in this area. What you don’t want to do is sell the house thinking you’re safe only to find out you technically don’t fit the exclusion and end up paying the feds a lot of money.
Alternatively, if the property is now entirely a rental property and you want to sell it, you can set up a 1031 tax-deferred exchange. You would buy a rental property that costs at least as much as the property you are selling. This would allow you to defer capital gains tax until you sell the new property. If you keep the property and pass it on to your heirs, under current tax law the property would receive an increase in value from the current market value at the time of your death.
Be aware that 1031 exchanges can be complicated and there are strict rules you must follow when identifying a replacement property and completing the sale. You can read some of our past columns on 1031 Exchanges here and here.
Ilyce Glink is the author of “100 questions every first-time home buyer should ask(Fourth Edition). She is also the Managing Director of Best Money Moves, an app employers provide to employees to measure and reduce financial stress. Samuel J. Tamkin is a Chicago-based real estate attorney. Contact them via the website, BestMoneyMoves.com.
©2022 Ilyce R. Glink and Samuel J. Tamkin. Distributed by Tribune Content Agency, LLC.
