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Tax Consequences of Selling a Personal Residence

Tax Consequences of Selling a Personal Residence

June 02, 2022
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Selling your house is often an adrenaline rush of excitement, mixed with leaving behind the nest in which you’ve stored memories of friends and family. It’s such a weird mix of happy and sad. It’s such an emotional endeavor that a few rules and regulations often get forgotten. One such example is this question I get from time to time: "I just sold my house; do I pay taxes on it?” The answer to this question: maybe.

The taxation on selling any real estate is generally assessed as capital gains tax (unless you qualify for active income in a real estate profession). Capital gains tax is assessed on the gain realized, not the full amount of the final transaction. For example, if I purchase a house for $100,000 and sell it for $150,000, then I gained $50,000, and I’m only taxed on the gain. So I have a capital gain of $50,000, and that gain would be taxed according to the capital gains rules.

To determine what amount of the sales price is gain, the cost basis of the primary residence must be calculated and subtracted from the total sale. The cost basis refers to the amount of money that was spent to purchase and acquire the home plus any improvement costs. The cost of property taxes, general maintenance & upkeep, and insurance costs do not adjust the cost basis. The only improvement costs that add to the cost basis of the house are additions/improvements that increase the value of the house. These are known as capital improvements. Insurance also can play a role in determining and adjusting the cost basis of your home. If you receive a casualty loss payment from your insurance policy, the amount of the insurance claim, in excess of any repairs, reduces the cost basis of the home. Once the cost basis is calculated and determined, the amount of gain can then be easily figured.

Currently (and it’s been this way for a while) there is an exclusion on the capital gains tax on a personal residence, but the exclusion comes with a few stipulations. The amount of gain that is excluded is $250,000 per person. The exclusion is listed on only one income tax return, so if you file married filing jointly, the $250,000 exclusion can be combined for both tax filers for a total of $500,000 of excluded taxable gain. If there is a realized profit, the profit is taxed as a capital gain if the profit is greater than the taxable exclusion.

There is a timeline condition that needs to be met to qualify for this exclusion. This condition requires you to live in your house as a personal primary residence for at least 2 years. If a person lives in the house for less than 2 years, an exclusion ratio will apply, where a partial exclusion is allowed on a pro-rata basis.

For example, if a person lived in a house for 8 months before selling the residence, then one-third of the exclusion would be allowed, or approximately $83,333.33 of gain would be allowed before taxes would be due. The formula is simple. Take the number of months divided by 24 (24 months = 2 years), then multiply ratio by the exclusion amount. The example above would work out to:

Exclusion ratio = (# of months living in the house/24) x exclusion amount, currently $250,000 per person, up to $500,000 per married couple.

(8/24) x $250,000 = (1/3) x $250,000 = $83,333.33 in primary residence gain exclusion

If the individual sold the residence for a gain greater than $83,333.33, the capital gains tax would be assessed as short-term capital gains since the house was purchased and subsequently sold in one year or less.

There are some exceptions to the 2-year condition. These exceptions are all determined by life events that occur during the year the house is sold (ideally, the house would be sold because of one of these life events). The primary exceptions are the following:

  • You must move to be closer to new job that was accepted.
  • You had a health change, and you must move to be closer to receive care.
  • You got married or divorced.
  • Unforeseeable events, such as:
    • Death of an occupant
    • Birth of multiples (twins, triplets, etc.)
    • Unemployment (must qualify for unemployment compensation)

If one of these life events occurs during the year in which your primary residence is sold (it’s supposed to be the reason the house was sold, but it’s generally acceptable if one of these events occur during the year the house is sold), then the $250,000 taxable exemption is available regardless of how long you have lived in the primary residence.

In the example above, where the house was purchased and subsequently sold in 8 months, the homeowner would receive the full $250,000 taxable gain exclusion if the house was sold to be closer to a new job in a new city.

What if you sell your home for a loss? For whatever reason, whether it be a housing bubble, falling real estate values, or fire sales, a personal residence is sometimes sold at a price lower than the cost basis. Normally, with a capital asset, a loss can be deducted against other capital gains, and a loss can even offset up to $3,000 of earned income. When selling a personal residence at a loss, there are no such tax benefits available, so losses in selling a personal residence cannot be utilized.

Selling your primary residence is a large and important transaction, so it’s important to understand the impact taxes might have on the proceeds. The emotions and adrenaline of scheduling showings and taking offers on your former home might cover up some blind spots for receiving your proceeds intact.

For even more information, you refer to IRS Publication 523.