The way to scale back your tax burden after promoting a worthwhile dwelling
Despite the cooling market, many homeowners have made money selling their property in 2022 — and some of that windfall could be taxable.
According to ATTOM, a nationwide real estate database, home sellers made a profit of $112,000 on a typical sale in 2022, a 21% increase from 2021 and a 78% jump from two years ago.
While most sellers fall below capital gains tax thresholds, high-priced home sales or long-term ownership can trigger an unexpected bill, experts say.
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Here’s how it works: Home sales gains qualify as capital gains with federal tax rates of 0%, 15%, or 20% depending on your taxable income in 2022. (You calculate “taxable income” by taking the larger of the standard or individual deductions deduct from your Adjusted Gross Income.)
As a single home seller, you can exempt up to $250,000 of your profits from capital gains tax and shield up to $500,000 if a married couple files together, provided you meet certain IRS rules.
However, you may owe capital gains taxes if your home equity profit exceeds these thresholds.
“It can be a pretty significant tax burden for people who aren’t aware,” said certified financial planner Anjali Jariwala, founder of FIT Advisors in Redondo Beach, Calif., especially for those with a lot of appreciation and embedded gains. She is also a certified public accountant.
How to qualify for $250,000 or $500,000 waivers
Most sellers’ profits fall under the $250,000 or $500,000 tax exemptions, but there are certain rules for qualifying, said Mark Steber, Jackson Hewitt’s chief tax information officer.
The first rule: you must pass the “ownership test” which requires you to have owned the property for at least two of the last five years prior to the sale.
There is also a “residence test” which states that the house must have been your “principal residence” for at least two of the last five years. But “it doesn’t have to be continuous,” Steber said.
“You get that break as many times as you want,” he said, as long as it’s been at least two years since you last claimed the exemption.
The IRS has some exceptions to the eligibility tests, including specific guidance for cases of separation or divorce, widowed taxpayers, military personnel, and more, which are outlined here.
Increase the “base” of your home to reduce tax liability
Many home sellers don’t realize that there is potential to reduce profits — and potentially lower capital gains — by increasing the purchase price of their property, known as the “base,” Jariwala says.
“Your home purchase price is the starting point for your base,” she said, explaining that you can cover the cost of “capital improvements.”
“If someone has had their house for 10 years and sells it, they may have forgotten about improvements they made,” like replacing the roof or putting in new floors, Jariwala said.
It’s really important to make sure you document all the things you’ve done to your home over the years.
Founder of FIT Advisors
“It’s really important to make sure you document all the things that you’ve done to your house over the years,” she said.
However, you cannot include repairs and maintenance such as painting or fixing leaks because these activities do not add value or extend the life of the home.
And if you calculate your home sale profit, you can recoup the costs incurred in selling your home, such as agent’s commissions or costs of repairing the property before the sale, Jariwala said.
If you plan to sell in the future, you can organize yourself with receipts to pinpoint what expenses could eat into your bottom line, she suggested. Otherwise, you may have to find out your basis before the tax deadline.
“You might just not have enough time to collect everything you want and then you’re leaving money on the table,” she said.
Of course, if you expect to make a sizeable profit, you can also consider the timing of the sale based on your expected income for the year or leverage strategies to offset tax liability. “You really have to look at it [tax] return holistically,” added Jariwala.