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Selling, Gifting & Bequeathing Your Home

Our last article focused on dispelling some of the tax misconceptions of buying and owning a home. Here, we will attempt to clarify the often misunderstood tax implications of selling, or otherwise, disposing of your primary residence. In general, any transaction that yields a profit is taxable. However, in 1997, Congress decided to make most profits from the sale of a primary residence tax free.

When Congress enacted legislation that allowed single taxpayers to exclude up to $250,000 of profit from the sale of their home ($500,000 for married couples), it was generally believed that most people would no longer have to worry about any tax ramifications. As long as you owned and used the house as your primary residence for at least two of the five years that preceded the sale, you kept all of the profit that did not exceed these limits. (This exclusion can be claimed once every two years).

Nevertheless, some homeowners, as a result of a soaring real estate market in the ensuing years, found that they had a long lost relative named Uncle Sam looking to share in their newfound fortune as their profits exceeded the exclusion amounts. Suddenly, such terms as adjusted basis, net sales proceeds and capital gains, as well as the need to save all of your Home Depot receipts, became important. Read on to learn more about these terms:


What is your adjusted basis?

  • The IRS defines basis as the amount of your total capital investment in a property for tax purposes. Certain events that occur during your period of ownership may increase or decrease your basis, resulting in an “adjusted basis.” Remember your HUD-1 closing statement that listed all of those non-deductible items from your home’s purchase? That is your starting point. Generally, your adjusted basis consists of the following:
  • Purchase price
    Add:

  • Closing costs such as –
  • Title insurance and charges
  • Appraisal fees
  • Credit report fees
  • Tax service fees
  • Flood certification
  • State and local recording, stamp and transfer taxes
  • Legal fees related to perfecting title
  • Home improvements – enhance the home’s value such as roof replacement, landscaping, a new kitchen, an extension, central heating and air conditioning. Repairs and maintenance do not enhance a home’s value and are therefore not a part of your basis
  • Restoration costs associated with a theft or casualty such as a hurricane or earthquake
  • Tax credits received after 2005 for home energy improvements
  • The cost of extending utility lines to the property
    Less:

  • Insurance proceeds from a theft or casualty loss
  • Tax deductible portion of a theft or casualty loss
  • Depreciation from the home’s rental or business use
  • Any deferred gain resulting from pre-May 1997 tax law sales
  • Any discharge of qualified principal residence indebtedness excluded from income

If you hired a contractor to build your home, your basis also includes the cost of the land, labor and materials, architect and legal fees, as well as utility meter and connection charges. The cost of your own labor is not included.

In certain instances, your basis is not determined by cost. If you receive property as a gift, your basis is the donor’s adjusted basis. If you inherit property, your basis is its fair market value on the decedent’s date of death. How your basis is determined can make a big difference tax-wise. Say an elderly mother is considering the alternative of transferring title to her home with an adjusted basis of $75,000 to her grown son with whom she does not live, as opposed to bequeathing it to him. If she transfers title to her son while she is living, she will have made a gift. As such, the son will receive his mother’s $75,000 basis. If he later sells the house for $300,000 without establishing it as his primary residence, he will be taxed on the $225,000 gain. There is no exclusion since it is not his primary residence. If, however, he lives in the house for at least two years, he will establish it as his primary residence. If he later sells the home for $300,000, he owes no tax since he qualifies for the $250,000 primary residence exclusion, despite the fact that his basis is only $75,000.
As an alternative, if he inherits the home from his mother, at which time the fair market value is $300,000, and immediately sells it for $300,000, there is no taxable gain since his basis is the fair market value on the date of death. It does not matter whether or not he lived in the home at any time.

Also, in general, divorcing couples take each other’s basis and recognize no gain on the transfer in cases where one spouse buys out the other’s interest in the marital home incident to divorce.


How are net sales proceeds calculated?

You will need to refer to your HUD-1 from the sale. Essentially, your net sales proceeds consist of the following:

  • Selling price
      Less:

    • Sales commissions
    • State and local transfer and recording taxes and fees
    • Fix up costs such as painting, maintenance and repairs to make the property more saleable


How do you calculate the gain?

Your gain is determined by subtracting your adjusted basis from your net sales proceeds. If you qualify for the exclusion, you would then reduce any gain by the exclusion to derive any taxable gain.


Do you have to report the sale on your tax return?

In general, you are not required to report a sale of your primary residence if you can exclude all of the gain (and elect to do so) unless you received Form 1099-S, Proceeds from Real Estate Transactions, which in the case of a home sale is issued if the proceeds exceed the exclusion limits. If it is reportable, it is included on Form 8949, Sales and Other Dispositions of Capital Assets, and Schedule D, Capital Gains and Losses, as a short-term capital gain if you held your home for one year or less, and as long-term if you held the property for more than one year.

Short-term gains are taxed based on ordinary income rates. The long-term capital gain rate ranges between 0% and 20%, depending on your tax bracket.


Can you deduct a loss from the sale of your home?

A loss on the sale of your primary residence is not deductible as it is considered personal property.


Can I exclude gain from the sale of a second home, rental or investment property?

The exclusion rules only apply to the sale of a primary residence. The Housing and Economic Recovery Act of 2008 (HERA) changed the rules for homes that are not used as a primary residence during the entire five year period and are sold after 2008. Under previous law, homeowners were entitled to the exclusion from the sale of a principal residence as long as the two-of-five test was satisfied. Under HERA, however, the exclusion is based on the period of time when the property is used as a primary residence (qualifying use) versus any other use beginning after January 1, 2009 (non-qualifying use) which will not be excluded and could trigger capital gains tax.

For example, a single taxpayer purchased a second home on January 1, 2009 and sells it ten years later on January 1, 2019, using it as a primary residence only during 2016 through 2018. The two-of-five test has been met, but because the home was only used as a primary residence for 30% of the total ownership period (three of the ten years), the capital gains exclusion cap is reduced to 30%, or $75,000 ($250,000 X 30%).

There are grandfathering provisions for existing owners of second homes that allow any time period of ownership prior to 2009 to be treated as qualifying use.

For example, a married couple purchased a second home on January 1, 2005 and sells it on January 1, 2015, using the home as a primary residence only during 2013 and 2014. Unlike the previous example, in which the taxpayer only had three years of qualifying use, under HERA’s grandfathering rule, six of the ten years qualify for the tax exemption (2005 through 2008 are grandfathered, plus 2013 and 2014). As a result, the couple can exclude 60% of the $500,000 gain exclusion, or $300,000.


Do you have to own and use the home at the same time in order to qualify for the exclusion?

The two year use and two year ownership requirements can be satisfied during different times within the five year window. A good example is those who rent with an option to buy. Once they purchase the rental home, the time that they lived in the home as a renter counts as use of the home for purposes of the exclusion, even though they did not own the home at the time


Are you still entitled to the exclusion if you are not living in the home at the time that you sell it?

You do not have to be living in the house at the time of sale to qualify for the exclusion. The two year ownership and use requirements may occur anytime during the five years prior to the date of sale. This means that you can move out of the house and rent it for up to three years prior to the sale and still qualify for the exclusion (subject to the HERA limitations discussed above). It is important that you keep track of, and document this time period to ensure that you sell the house before the three year period expires.


Must you use the proceeds from your home sale to buy another residence in order to exclude the gain from tax?

No. Prior to the law being changed in 1997, to avoid paying tax on the sale of a residence, a homeowner had to use the sale proceeds to buy another house that cost as least as much as the amount for which the old home was sold. Even then, this was a gain deferral, not an exclusion. Any deferred gain was deducted from the adjusted basis of your new home, thereby increasing the gain on any future sale for which there was no replacement dwelling. Home sellers age 55 or older were allowed a once-in-a-lifetime tax exemption of up to $125,000 in sale profit. This law no longer applies. Under current law, any qualifying gain is free of tax to the extent of the exclusions discussed above. You do not have to buy a replacement home, nor are there any gain deferrals.

For more information, please contact Victor C. Belgiorno at 516-861-3704 or  or Bob Jahelka at 516-861-3707 or .

 
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