Except when you are selling for financial distress, selling the home is expected to yield a lot of profit for you. But there's a pitfall: capital gains tax. So many homeowners wish to know how to make the maximum gains from the sale without paying extra. Because home sales profits are regarded as capital gains, they are taxed as such.
However, some strategies allow you to cash out of your home tax-free. With home sale value increased over the last few decades, there has never been a better time to cash out.
As a result, how do you do that without losing a chunk to taxes? We'll outline the best strategies to allow you to do this and make as much profit as possible from your sale.
Ownership and Use
First, from May 6, 1997, if you're a homeowner, the Taxpayer Relief Act allows the IRS to exclude up to $250,000 of your capital gain from tax when you sell your home. If you're a married couple who jointly own a home and file, you can exclude $500,000. To be eligible, you must pass the ownership and use test, which implies that you must have owned and lived in that home for at least two out of five years before the sale.
Let's see how it works.
You're most certainly going to profit when you sell your home. If you're a couple and make a profit of less than $500,000 from selling your home, you are not expected to pay any capital gains tax.
How do you calculate your gain?
Your gain is not just the selling price minus buying price. Many other expenses are factored into the cost before you can calculate the gain. They include any fees for improvement of the home, costs of putting up the house for sale, and the depreciation costs of the home.
Let's look at a practical example of a couple that sold their home for $800,000 after purchasing it for $250,000, which leaves a profit of $550,000. Although the limit for capital gains is $500K, factoring in other expenses like improvement costs, depreciation, and insurance payments would likely shoot beyond $50,000. Factoring these expenses into the buying cost would mean that the couple owes zero dollars in capital gains.
The ownership and use test is not cast in stone. You may still be eligible even if you've not met the criteria, depending on why you move. Also, if you do not meet the two-year requirement, let's say you lived in the house for only one year before the gain, you can claim half of the exclusion. If a couple's profit on a home is less than $250,000, and they only pass half of the ownership test, they are still eligible for up to $250,000, thereby claiming all of the profit. Single homeowners can also benefit from up to $125,000 if they meet half of the criteria.
Because capital gains deductions are only worthwhile for primary residences, homeowners can also decide to convert a secondary home to a primary one and meet the requirements of living there for two years before the sale.
1030 Exchange
Another way by which you can avoid payment of taxes on a home sale is by reinvesting proceeds of the sale in what Section 1030 of the IRS code calls a like-for-like exchange.
In this case, you can exchange your property for another one without being taxed for whatever the gain on the transaction is. Although the taxes on the income are not eliminated, they are deferred. However, the properties subject to the 1031 exchange must be used for investment purposes.
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