It is a common problem. You have owned your home for many years and now you would like to sell the home. The good news is that the home has appreciated significantly in value over the years. The bad news is that there could be a nasty tax bill when you are ready to sell. Are you trapped? Is there any way to avoid, reduce, or defer the gain? Thankfully, the answer is yes. There are tax provisions that can help. Here is a quick overview.
Residence or Rental?
The first question to ask is whether the house is or has been your primary residence. The tax treatment for your primary residence is very different from the tax treatment on a rental property. For purposes of this article, we will focus on residences, not rental properties.
Calculating the tax
Many are surprised to hear that the gain from the sale of your primary residence could be subject to tax, so don’t get caught unaware. The ‘gain’ is the proceeds from selling your home less the cost basis in your home (usually what you paid for the house plus any improvements you made). The gain is NOT the difference between the sales price and the mortgage balance, so be careful to avoid confusing your mortgage balance with your ‘basis’. Also, remember that improvements you have made to the house over the years can be added to your basis. It is important to keep good records and get credit for all the money you have put into the house.
The “$500,000 Exclusion”
Once you have calculated the gain, you can apply the “exclusion of gain from sale of principal residence”, code section 121. Section 121 allows a taxpayer to exclude up to $250,000 of gain from the sale of a home, or up to $500,000 if filing jointly. To qualify for the exclusion, you must pass both the ownership test and the use test, which requires you to have owned and used your home as your main home for at least two years within the five years leading to the sale.
Some people use the strategy of moving into a rental property to get the Section 121 exclusion but be very careful with this strategy because the rules have changed. You can no longer simply move back into your rental property for two years and claim a full $250,000 per person exclusion. Effective January 1, 2009, you must now prorate the exclusion based on the amount of time you lived in the property divided by the length of ownership.
On the other hand, there are several exceptions that may allow you to claim the exception even if you don’t meet the basic requirements. These exceptions include “unforeseen circumstance” such as divorce or natural disaster. If you are unsure if the exclusion applies in your situation, I suggest you consult your tax advisor.
What if you still have a taxable gain?
If the gain on sale of your primary residence is greater than the exclusion then you could have a taxable gain on the sale, normally a long-term capital gain, which will be taxed at 15%-20% for Federal purposes and will also be taxed at your state rate. This could mean a steep tax bill. Is there anything more that you can do?
There are additional strategies to employ, but these are more sophisticated, and I highly recommend discussing the pros and cons with your tax advisor. Sometimes, it is better to simply pay the tax and avoid any potential pitfalls. However, here are a few examples of potential strategies to employ.
Installment sales
In an installment sale, the seller accepts payment in the form of a promissory note and receives payment over a predetermined period. This approach defers the tax liability until the payments are received, potentially lowering the overall tax bill. Note that the seller will take on the credit risk of the promissory note, so installment sales should be approached with caution.
Deferred Sales Trusts
A deferred sales trust is similar to an installment sale but places a trust between the buyer and seller. The buyer funds the trust which invests the cash. The trust then buys the home and pays the seller in installments. Using this approach, the seller avoids the credit risk of the buyer but is still exposed to the credit risk of the deferred sales trust. Once again, these transactions should be approached with caution.
Charitable Remainder Trusts
A charitable remainder trust that pays income to beneficiaries during life and then passes the principle to a charity upon the death of the income beneficiary. This transaction can be used when selling your home to convert it to lifetime income. For example, you can donate your home to a charitable trust, which then sells the home, avoiding the capital gain. The proceeds from the sale of the home can then be invested, providing income for your life. Upon your death, any remaining funds are transferred to the named charity. Once again, these are complex instruments that should be approached with advice and caution.
Of course, there are more strategies that could be employed, but this list shows some key examples of strategies you could potentially use. Always consult with your tax advisor.
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