The home gain exclusion and important things to consider that may impact your eligibility and the amount of gain you are able to exclude under this provision.
Death and taxes—these are the only certainties in life. Yet, while the IRS rarely misses an opportunity to take a piece of your pie, there are several provisions in the federal tax code that are designed to give homeowners a break. One of these provisions is the home gain exclusion, also frequently referred to as the primary residence exclusion. Many individuals fail to understand the details and requirements of the home gain exclusion and, as a result, they fail to take advantage of this option or underutilize its potential benefits.
In this article, we will explore some common questions concerning the home gain exclusion and important things to consider that may impact your eligibility and the amount of gain you are able to exclude under this provision. It is important to consult a financial advisor and/or certified public accountant (CPA) to discuss your individual circumstances and eligibility for this significant tax benefit.
What is the home gain exclusion?
If you sell your home for an amount greater than your adjusted basis in the home—your initial investment adjusted by various factors like improvements to the home—you have a capital gain that the IRS wants to know about. Capital gains are subject to a special tax, creatively known as a capital gains tax. Unsurprisingly, financially savvy individuals try to take advantage of every exclusion or opportunity that the tax code allows to avoid paying more taxes than necessary. One option you can utilize to avoid paying capital gains taxes on the sale of your home—or at least limit your capital gain tax liability—is the home gain exclusion.
If you qualify for the home gain exclusion, you may be able to exclude up to $250,000 from your income or up to $500,000 if you are married filing jointly. To qualify, you must meet the ownership test and the use test. The ownership test of the home gain exclusion requires that you owned the home for at least 2 out of the last 5 years prior to the sale of the home. Under the use test, you must have used the home as your primary residence for an aggregate period of at least 2 out of the last 5 years before the date of sale. While the ownership test and the use test must both be met in the 5 years immediately preceding the sale of the home, they can be satisfied in different 2-year periods.
Can I qualify for a partial home gain exclusion?
Many people do not know that even if you do not meet all the criteria for home gain exclusion, you may still be able to exclude a partial amount of the capital gains you realize from the sale of your home. If you are not eligible for the home gain exclusion because you do not meet the ownership or use test as a result of moving early due to work, health reasons, or to care for an ill family member, you may be able to exclude a prorated amount.
Specifically, the IRS allows for an exception to the 2-year ownership and use requirement if you were forced to move due to a change in employment or health problems. In addition to these reasons, the IRS also provides somewhat of a catch-all provision for “unforeseen circumstances” that you did not consider when purchasing the home such as a natural disaster, a death in the family, unemployment, the birth of twins or another multiple birth, or not being able to afford to remain in the home due to a change in marital status or employment.
However, just because a situation causes you to move does not mean that the IRS will recognize it as an unforeseen circumstance. Some examples where the IRS has refused to approve unforeseen circumstances for the partial home gain exclusion include imprisonment, environmental problems, or a decline in the market.
How does investment into home improvements effect my home gain exclusion?
Money spent on home improvements is relevant to your overall home gain exclusion to the extent that it increases your adjusted basis in the home, thereby potentially lowering your capital gains at the time of sale. By failing to consider the investment you may have made by remodeling the kitchen, bathrooms, and any other home improvements, your capital gains will be calculated to be higher than they should be, as money spent on home improvements increases your basis in the home dollar for dollar. If you do not consider these costs and investments, then you might incorrectly calculate your capital gains to be higher than the amount subject to exclusion under the home gain exclusion and end up paying unnecessary capital gains taxes.
For example, let’s say you purchased your home in 1980 for $100,000. During the time you owned the property, you invested $50,000 into the home to add an addition, replace the roof, redo the plumbing, and remodel the kitchen. In 2018, you sold the property for $400,000. You are single and, when filing your taxes, you completely forgot or did not know to calculate your adjusted basis in the home to include the $50,000 in improvements that you made to the property. So, you calculate your capital gain to be $300,000. You are only eligible to exclude $250,000, so you determine that you are liable to pay taxes on your capital gain of $50,000. If you were knowledgeable about the role of home improvement investments in calculating your adjusted basis in the home, you would have known that your adjusted basis was $150,000 and your total capital gains were only $250,000. As a person filing single, you would be eligible to exclude the full amount of your gain of $250,000 and pay zero in capital gains taxes.
Can I simply gift my home to my child to avoid capital gains taxes?
There are very few instances where it is financially advantageous from a tax perspective to gift your home to one of your children. The most common reason for considering this strategy is to try to protect the assets from creditors or Medicare or avoid paying capital gains taxes. However, gifting your property does not guarantee that you will accomplish any of those objectives. When you gift your home to your child, they take your tax basis in the property and will owe capital gains taxes on the difference between that original basis and the selling price, unless the child lives there for at least two of the last five years before selling. Additionally, even if your family saved money on capital gain taxes by using this strategy, you would still be required to pay taxes on your gift. Depending on your individual circumstances, the amount of gift tax you owe will vary but you are only eligible to exclude $15,000 of the gift if you file as single or $28,000 if you are married filing jointly.
Can I combine my home gain exclusion with a 1031 exchange?
A particularly underutilized strategy for reducing or deferring your capital gains tax liability is to combine the benefits of a home gain exclusion with a 1031 like-kind exchange. A 1031 exchange allows you to reinvest the proceeds of a sale of real estate investment property, rental property, or property used for business purposes into a similar property without paying capital gains taxes. Effectively, this strategy allows you to defer your capital gains tax liability.
The tricky part about combining the home gain exclusion and a 1031 exclusion is that to be eligible for the home gain exclusion you must have used the property as your primary residence and to take advantage of a 1031 exchange, you must have held the property for investment of business purposes. However, there are three scenarios in which you can combine these seemingly opposing options: you acquired the property as rental property and later moved into the rental property yourself and lived there for at least 2 years; you acquired the property as a like-kind 1031 replacement property, held the property for a period of time as rental property and then later converted it to your primary residence for at least 2 years; or you acquired the property as a primary residence and lived there for at least 2 years of the 5 years preceding the date of sale of the property, but then moved out and converted the property to a rental property before selling it.
These requirements are very strict and specific, so it wise to consult a professional tax advisor when seeking to combine these strategies. Ideally, you will consider this benefit ahead of time when planning your decision to convert a rental property into your primary residence or move into a property that you acquired in a 1031 exchange.
The home gain exclusion can be a powerful advantage in your financial and tax planning strategy. It is very important to seek advice from your financial advisor on the best way to protect your assets and minimize capital gains tax liability. Our experts at Anderson Business Advisors have assisted countless homeowners on the most advantageous options for reducing or even completely avoiding capital gains taxes. Contact us today for a consultation.
About the author:
Mr. Bowman, Attorney and Author is a Partner with Anderson Law Group in the firm’s Las Vegas office. He received his Bachelor of Science degree in business from Arizona State University. After spending five years in the computer industry, Mr. Bowman received his Juris Doctor from Seattle University School of Law and is licensed to practice in multiple states. His experience includes commercial and civil litigation, construction defect law, complex real estate transactions, and business law. Throughout his career, Mr. Bowman has been known as an attorney who formulates and executes winning legal strategies. In addition to his legal experience, Mr. Bowman is an avid investor in real estate and the stock market.