My parents have lived in the same house in eastern North Carolina for 45 years. That’s rather remarkable considering that most Americans don’t stay put: we move, on average, nearly 12 times in our lifetimes.
Moving house is especially appealing right now. Record-low mortgage rates combined with a limited number of houses for sale have created a seller’s market: prices are soaring, and homes are selling almost as quickly as they can be listed. A local real estate agent told me that buyers are going to extremes to acquire properties, including all-cash payments with limited or no contingencies.
Selling your home
The hot real estate market is causing homeowners to wonder: Is it the right time to move? Many factors go into these conversations—and taxes should be one of them. Here are a few tax considerations when selling your home.
The capital gains exclusion is available to all qualifying homeowners. Before 1997, homeowners were subject to capital gains tax when they sold their primary home but could get a break if they bought a replacement home worth the same or more. There was also a provision that allowed homeowners age 55 or older to claim a one-time capital gains exclusion. That’s no longer the case. The Section 121 exclusion—on capital gains up to $250,000 of the gain from your income, or $500,000 for married taxpayers—is available to all qualifying taxpayers who have owned and lived in their home for two of the five years before the sale. The years don’t have to be sequential: you can live in the house in year one and in year five and still qualify.
You can convert a rental into a primary residence. You don’t have to buy a property intending for it to be your forever home, but if it works out that way, you may still benefit from the exclusion. If you move to a space that was previously a rental, the years—for purposes of the residency rules—don’t have to be consecutive. A quick caution: Congress is wise to taxpayers who hope to game the system, so depreciation recapture rules may apply. Additionally, the period the property wasn’t used as your primary residence could be deemed a “nonqualifying use” and the gain may be subject to an adjustment.
You’re not limited to one capital gains exclusion during your lifetime. The capital gains exclusion applies to your principal residence, and while you may only have one of those at a time, you may have more than one during your lifetime. You can use the exclusion as many times as you qualify. And while you can’t claim real estate as your primary residence if you don’t live there, if you move into your vacation house or investment property for two years—and otherwise meet the criteria—you can take the exclusion on a subsequent sale.
Outside of the exclusion, the “normal” capital gains rules apply to the sale of your home. That means if you own your home for one year or less and then sell or otherwise dispose of it, your capital gain is short-term, and you’ll be taxed at your ordinary income tax rate. However, if you own your home for more than one year before you get rid of it, your capital gain over and above the exclusion is long-term. For 2021, the long-term capital gains rates for most capital assets are 0%, 15%, or 20%, depending on your taxable income. Special rates and limits may apply.
You can’t claim a capital loss if you lose money on the sale of your home. While it’s true that you must pay tax on capital gains from the sale of a personal residence, the opposite isn’t true. You can’t claim a capital loss on the sale of a personal residence—no matter how much it hurts.
But what if you’re thinking about selling something other than your personal residence, like your vacation yurt or the flip you’ve been eyeing down the street?
Investor or dealer?
The tax consequences of buying and selling real estate besides your personal residence largely hinge on whether the IRS considers you an investor or a dealer. Those terms can be a little confusing because most taxpayers eyeing a flip probably consider themselves investors while the IRS would characterize you as a dealer.
What’s the difference? There is no clear test for investing versus dealing—it’s based on facts and circumstances. The IRS looks at several factors, including motive and timing. Taxpayers who are in the business of flipping homes—especially multiple homes—are typically treated as dealers or real estate business owners. But those who hope to profit long-term are often regarded as investors.
Why does it matter? There are many tax consequences, but primarily, the focus is on the characterization of the property. Dealers, like other business owners, acquire inventory, not capital assets. When the flip is complete, the income is reportable just as any other business on a tax return. For non-corporate taxpayers, that means it shows up on a Schedule C, and self-employment taxes apply. But it also means that related costs are deductible as business expenses, even if it results in a loss.
If, however, a taxpayer buying and selling real estate is treated as an investor, the property—like that vacation home you bought years ago—will be considered a capital asset. The gain will be taxed as capital gain, which typically means more favorable rates— but if you lose money, the $3,000 limit on capital losses will apply. While investors are limited when it comes to expenses, you can deduct mortgage interest and real property taxes—subject to the usual rules, of course. That makes writing that check to the local authorities for your vacation home a little less painful.
Remember: gains and losses don’t have to match up. You don’t have to offset gains from stocks with losses from stocks or gains from bonds with losses from bonds. The same is true with gains from the sale of real estate. With few exceptions, a gain is a gain, so factor real estate gains or losses into any year-end tax planning.
And speaking of tax planning, keep in mind that the rules related to buying and selling real estate can be complicated, especially if you mix in partners or create entities to hold the properties. While I don’t believe you should make tax your primary consideration if you’re contemplating a flip—let’s face it, we all secretly want to be Chip and Joanna Gaines—you should understand the basics before getting started. Better yet, if you’re planning to get your hands dirty with a new real estate project, let your tax professional do the heavy lifting.
This is a weekly column from Kelly Phillips Erb, the Taxgirl. Erb offers commentary on the latest in tax news, tax law, and tax policy. Look for Erb’s column every week from Bloomberg Tax and follow her on Twitter at @taxgirl.