The market is sizzling for home sellers, and President Biden wants to raise taxes on long-term capital gains for people with incomes above $1 million.
These two facts make it a good time to focus on the cherished tax break known as the home-sellers’ exemption, both to see how it applies now and how Mr. Biden’s proposals would affect it. Although his proposals explicitly preserve this exemption, some homeowners with large gains would likely owe more if it is enacted.
The home-sellers’ exemption allows millions of Americans to skip taxes on a large chunk of appreciation when they sell their homes—up to $250,000 of profit for single filers and up to $500,000 for married couples filing jointly (and some widows and widowers). These exemptions haven’t changed since enactment in 1997, and they’re not adjusted for inflation.
For most homeowners, this benefit easily wipes out taxes when they sell. The median gain for U.S. home sellers in the first quarter of 2021 was a near-high of $70,050, according to Attom Data Solutions, which tracks real-estate data.
Sellers in high-end markets are bumping up against the exemption’s limits or exceeding it, however. The median first-quarter seller gain was $575,000 in parts of Silicon Valley and $420,000 in San Francisco and parts of Alameda County, according to Attom.
“For many Americans, their home is such a key asset that this will be the largest single tax break they ever get. It’s important not to mess it up,” says Julian Block, a tax attorney and author of books on real estate taxes.
If you’re jumping into this seller’s market, here’s what to know about this benefit.
Who qualifies for the home-sellers’ tax break?
The exemption, which the tax code calls an “exclusion” for technical reasons, is available only to taxpayers selling their primary residence. Single filers get an exemption of $250,000 of net gain on a sale, and married couples filing jointly get $500,000.
To qualify, a single seller must have owned and lived in the house for at least 24 months of the five years ending on the sale date. For a couple to get the full $500,000 break, both spouses must have lived in the house for 24 months of the past five years, and at least one spouse must have owned it for 24 months of the past five years.
There are many nuances to these rules, such as for separated or divorced couples, military personnel, and homeowners who enter nursing homes, and some sellers qualify for partial exemptions. For sellers with unusual situations, Internal Revenue Service Publication 523 has helpful explanations. Consulting a tax professional before the sale could be a good investment.
Can a homeowner take the $250,000/$500,000 tax break more than once?
Yes. Sellers who meet the requirements can use the break as often as every two years.
What is “net gain?” Does that include improvements to my home?
Net gain is a homeowner’s selling price minus the cost basis—the purchase price plus any adjustments. Adjustments can include the cost of home improvements, legal fees and broker’s commissions.
If Marjorie buys a house for $300,000 and sells it for $500,000, her cost basis is $300,000 and her net gain is $200,000. Because of her $250,000 home-sellers’ exemption, Marjorie doesn’t owe tax on the sale. But if she sells for $575,000, she’d have a net taxable gain of $25,000.
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Homeowners can increase their cost basis and thus lower their gain if they make improvements—but not repairs. If Marjorie spends $5,000 on landscaping and another $50,000 to add space, her basis could rise to $355,000.
The definition of “improvement” can be tricky: A new roof counts as an improvement, not a repair. For an IRS list of which is which, see Pub. 523.
What if the net gain on the home sale exceeds the full exemption?
The excess is taxed at applicable capital-gains rates, likely 15% or 20%, depending on income.
For most sellers with adjusted gross income above $200,000 for a single filer or $250,000 for married joint filers, a 3.8% surtax will likely apply to some or all of the gain above the $250,000/$500,000 exemption.
My spouse died. Does that make a difference if I sell our home?
It could make a big difference. The surviving spouse can often get the full $500,000 exemption if the home is sold within two years of the first spouse’s date of death and the survivor hasn’t remarried.
No matter when the house is sold, the survivor could also get a welcome benefit under current law if the home was owned jointly—as many are. In that case, half the home’s value allotted to the spouse who died often gets a tax-saving “step-up” in cost basis as of the date of death. In community-property states like Texas or California, the benefit can be even better: a full step-up.
Here’s a simplified example from Chris Hesse, a principal at the accounting and advisory firm CLA.
Jack and Kate live in New York and bought a house together for $300,000 that is worth $900,000 when Jack dies. Because of the step-up provision, the cost basis for Jack’s half of the home rises to $450,000, while Kate’s half still has a basis of $150,000. Thus Kate’s new cost basis in the home adds up to $600,000.
If Kate sells this home in 18 months and hasn’t remarried, her starting point for measuring taxable gain will be $600,000, plus she gets the exemption of $500,000. So her selling price would have to exceed $1.1 million before she’d owe capital-gains tax. If she sells the home in three years instead, then the home’s cost basis will be $600,000 and she’ll get a $250,000 exemption, so she’d owe tax if she sells for more than $850,000.
Now say that Jack and Kate instead live in California, which is a community-property state. In that case, the cost basis of the house at Jack’s death becomes its full market value of $900,000. If Kate sells the house within two years for $1.4 million or less, she won’t owe tax. If she sells in three years, the tax-free amount drops to $1.15 million.
“People in states without community-property laws are envious of the additional step-up benefit of community-property states. States could fix that by changing the law, as Wisconsin did,” says Mr. Hesse.
I run a business from my home. Does that make a difference when I sell?
It could. You still get the exemption, but you may have to lower the cost basis of the home, which increases the profit, if you took tax deductions for some of the home’s expenses for your business. This prevents double-dipping of tax benefits.
This can be very complicated, so consider consulting a tax professional.
I plan to sell my current home and move to my vacation home I’ve had for years. Can I get the $250,000/$500,000 exemption on that home if I sell it in three years?
Not all of it, says Mr. Block. The exemption depends on how long the seller owned the vacation home before moving there permanently.
He says that if a couple has owned a vacation home for 10 years and used it as a primary residence for three when they sell, then they can take only 30% of the exemption, or $150,000. If they lived there for eight years out of the 10 they owned it, they’d get a $400,000 exemption. Note: There’s a partial exception for second homes owned before 2009.
How would Mr. Biden’s tax proposals affect my home sale?
Many sellers with gains within the $250,000/$500,000 limits wouldn’t be affected, because the proposals retain the home-seller exemption.
Home sellers with gains exceeding those limits who have annual income above $1 million would owe a 43.4% rate on the portion of their total long-term capital gains above $1 million. If income is less than $1 million, the top rate on the gains would apparently remain 23.8%. Under the current Biden proposal, these rates would apply to sales after late April, 2021.
If a homeowner dies, the proposal appears to limit the automatic tax-free step-up for half the value of the home or all of it, as described above. Instead, the total tax-free step-up on the home of the person who died would be the $250,000 home seller exemption, plus up to $1 million more. That $1 million would be available to shield taxes on the home appreciation, if it hasn’t been used for gifts during life or other appreciated assets held at death.
Under the administration’s plan, the step-up provision would take effect for 2022 and it would raise taxes on some people at death, leaving less for heirs. Mr. Biden’s proposals to raise capital-gains taxes are meeting intense opposition, and they have to go through Congress. So what will happen isn’t clear.
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