Chapter 16
Income Tax Filings after the Sale
IN THIS CHAPTER
Understanding your house-sale profits from a tax standpoint
Managing your state tax filings
You’ve successfully sold your old house and moved into your new dream home. “At last,” you think to yourself, “I can get on with my life and stop spending so much of my leisure time on housing decisions, transactions, and paperwork.”
If the idea sounds too good to be true, it is. Unfortunately, the Internal Revenue Service (IRS) and most state tax agencies may want to know all about the sale of your house because you may owe income tax on profits that you receive from the sale. This chapter helps you square away any tax-related issues you may encounter when selling your house.
Profits from a House Sale
If you sell your house for a profit, you can legally avoid paying income tax on that profit as long as you meet certain requirements. Wanna know how? Check out this section.
Defining profits
Most people sell their houses for more money than they originally paid to purchase them. The difference between the price you pay to buy a home and the amount you receive when you sell it is generated by some combination of two factors:
- Increases in value that have nothing to do with you (the rising tide of real estate prices)
- Improvements you put into the place
Fortunately, the IRS only defines the first factor as potentially taxable profit.
Suppose you buy a house for $245,000 and sell it ten years later for $345,000. While you owned the place, you spent $20,000 remodeling the kitchen and bathroom. According to the IRS, your profit on the sale is $80,000.
Later in the chapter, we get into more of the nitty-gritty details about all the items that the IRS requires you to consider in calculating your house sale profits.
Excluding house sale profits from tax
So, you’ve made a profit of $80,000 on the sale of your home (from the preceding section). How much federal income tax do you owe on it? Probably none.
In fact, thanks to the Taxpayer Relief Act passed in 1997, single taxpayers can realize up to $250,000 of profit and married couples up to $500,000 of profit on a house sale without having to pay any federal income tax on it. Most people’s house sale profits fit well under these limits.
As long as the house you’re selling has been your principal residence for at least two of the previous five years, you can take the tax exclusion at any age and for as many times in your life as you want (but not more than once every two years). There are no restrictions on what you must do with the profits; you can trade up, trade down, dump it all in the stock market, stuff it all under the mattress … it’s up to you.
Here are some other important rules and insights regarding this terrific tax break:
- For a married couple to qualify for the $500,000 exclusion, both spouses must individually meet the qualifications. That is, each spouse must have lived in the house for two of the previous five years, and neither spouse can have taken an exclusion on another house sale during the previous two years. If only one spouse qualifies, then the couple is allowed only a $250,000 exclusion.
- If you fail to meet the two-year requirements because of an unexpected move relating to your job, your health, and so on, you’re still entitled to a prorated amount of the exclusion based on how much time of the two-year requirement you were able to meet. For example, if you’re forced to sell after only one year and you meet the other requirements of this tax break, you’re entitled to 50 percent of the capital gains exclusion ($125,000 for a single person and $250,000 for a married couple filing jointly).
- How you hold title to the property affects your capital gain when the owner dies. If you hold title to your house as a joint tenant with another person, you get a stepped-up basis for tax purposes on half of the property when the other joint tenant dies. If the title to the house is held as community property, both halves of the house get a stepped-up basis when one spouse dies. See the glossary and a good tax/legal advisor for more details.
Tax Filings Required after the Sale
After you sell your house, you don’t need to immediately report the sale to the IRS. Rest assured, however, that the IRS knows of the sale because the firm that handles the closing (typically an escrow company) reports the financial details of the sale on Form 1099-S, Proceeds From Real Estate Transaction (see Figure 16-1), if required. You should receive a copy of this form, as well. Form 1099-S must be filed to report the sale of real estate unless the sale price is less than or equal to $250,000 ($500,000 or less for married couples) and all the sellers provide written certification that the full gain on the sale isn’t subject to taxation.
Source: Internal Revenue Service
FIGURE 16-1: Form 1099-S reveals your sale’s details to the tax authorities.
Schedule D: Capital Gains and Losses
When the time comes to file your annual IRS Form 1040, you may need to complete Schedule D: Capital Gains and Losses (see Figure 16-2) if you sold your house. Use Schedule D to report to the IRS that you’ve sold your house and determine whether you owe federal income tax on the profit.
Source: Internal Revenue Service
FIGURE 16-2: The Schedule D: Capital Gains and Losses form.
After you’ve calculated your profit on the sale, figuring out how much, if any, of that gain is taxable is quite simple, thanks to the capital gains rules for all houses selling after May 6, 1997. As long as the property has been used and owned as the sellers’ principal residence for at least two of the five years before the sale, married couples are allowed to exclude up to $500,000 of profits from tax and single taxpayers up to $250,000. If your profits are less than your allowable exclusion, you owe no federal income tax on the sale.
The following sections walk you through relevant information on the form.
Figuring your taxable gain on sale
The first parts of the calculations are the more difficult. You need to tally the expenses involved in selling your house, and you need to determine the amount the IRS calls the cost basis of the house. Determining the cost basis gives many a house seller a headache because that figure reflects not only the amount you originally paid for the house but also the money spent on improvements while you owned the property.
Calculating your gain on the sale, you need to determine two important numbers: the expenses of sale and the adjusted cost basis of the house you sold:
Expenses of sale: After selling your house, the IRS allows you to deduct from the selling price certain expenses incurred in the transaction, such as
- Real estate agent commissions
- Attorney fees
- Title and escrow fees
- Recording fees
- Advertising expenses
- Buyer’s loan fees
Unfortunately, paying off your outstanding mortgage does not count as an expense of sale.
Adjusted cost basis: For tax purposes, the cost basis of your house starts with the price you originally paid for it, including certain closing or escrow costs, which the IRS allows you to add to the purchase price of the house. During the time you own the house, however, that basis can change. Home improvements increase your cost basis by the dollar amount you spend on them.
In the eyes of the IRS, an improvement is anything that increases your home’s value or prolongs its useful life, such as landscaping, installing a new roof, adding rooms, installing a new heating or air conditioning system, and so on. On the other hand, repairs that simply maintain your home’s condition — fixing a leaking pipe, repainting, replacing a broken window, spackling holes in walls and baseboards — aren’t considered improvements.
Another factor that may affect your cost basis is depreciation taken for rental or business use of a portion of your property over the years. For example, if you convert your two-car garage into a tattoo parlor or if you’re renting a spare room, you can take depreciation on the portion of the property devoted to business or rental purposes. Depreciation reduces your property’s cost basis. (Note: The portion of your property devoted to business or rental purposes isn’t eligible for the tax deferral under the primary residence tax deferral rules. See Chapter 18 for more details.)
Here’s a simple example to show how the IRS wants you to calculate the gain on your house sale. Suppose you bought your house for $150,000. Through years of ownership, you spent the following on improvements:
- $6,000 on a new roof
- $2,500 on landscaping
- $1,500 on new electrical wiring
Thus, you raise your cost basis in the property to $160,000.
You sell the house for $250,000. However, after paying real estate commissions and other expenses of sale, you only receive $225,000. Thus, your profit as defined by the IRS comes to 
.
Understanding exclusion and taxable gain
Taken from the example in the preceding section, a $65,000 profit incurs no federal income tax, regardless of whether you were single or married. If your profits are greater than your allowable exclusion, then you pay capital gains tax on whatever amount exceeds the limit. Say you’re married and the profit on your house sale is $540,000. You owe tax on $40,000.
The actual rate you pay on this amount depends on your tax bracket and how long you owned the house. However, if you owned the house longer than 12 months, you pay no higher than 20 percent, which is the maximum long-term capital gains rate (it can be 15 percent or 0 percent depending on your income bracket). You may also owe an additional 3.8 percent surtax per the terms of Obamacare.
State income taxes on housing profits
The federal government isn’t the only government entity that assesses and collects taxes on income (which includes capital gains) — the vast majority of states do as well. Most states simply use the same capital gains exclusion rules that the federal government uses. Thus, if you don’t owe federal income tax on the sale of your house, you probably won’t owe state income tax either. Check with your state income tax entity or a local tax advisor for more details.