It took only nine years, but the real estate market has finally surpassed pre-2008 financial crisis level prices. Granted, not all parts of the country’s real estate market have risen as quickly, or to as high a level. If you bought property near the peak of the real estate mania or spent a fortune on renovations – or a combination of both – you may still end up selling for a loss.
Gains and losses are realized when capital assets are sold. The IRS considers pretty much everything you own to be a capital asset, including real estate, cars, stocks or bonds, collectibles and even your couch at home. If you sell the capital asset for more than you paid for it and earn a profit, you are subject to tax on the gain. If you end up selling for less than your cost, you incur a loss. In most cases, capital losses can be used to offset capital gains, and unused losses can be carried into future years to offset capital gains. However, losses on personal-use assets are generally not deductible.
Let’s see how the IRS treats gains and losses for real estate property.
The IRS treats personal-use property, like your primary residence or car, differently than investments. If you sell your house for less than your original cost plus improvements, i.e., adjusted cost basis, you can’t use the loss to offset any other capital gains or carry the loss forward into future years. To even things out, each spouse receives a $250,000 exclusion on the gains, thereby reducing the chances of you having to pay any capital gains taxes on the sale of your home.
To receive this full exclusion, you must meet the following criteria.
- You’ve used the home as your primary residence for two out of the past five years (use test).
- You’ve owned the home for two out of the past five years (ownership test).
- You did not use the home sale exclusion in the past two years.
In the event you don’t pass the use and ownership tests above, you may still be eligible to receive a partial exclusion if your reason for selling the home was due to an “unforeseen circumstance.” According to the IRS, these events include relocation for work, divorce or legal separation, birth of twins or more, becoming eligible for unemployment compensation, and damage of house due to natural or manmade disasters or condemnation.
As an example, consider a couple who bought their home for $500,000 and spent $100,000 on improvements, such as renovating their kitchen or bathrooms. Due to the improvements, the couple’s adjusted basis in the home is now $600,000. Remember, improvements increase your basis, while repairs are considered expenses and don’t count toward your cost basis.
The following four scenarios consider the tax implications of this couple selling for a loss, and for a gain.
The couple sold the home for $750,000 after just three years of living in the house. Since the couple’s adjusted basis was $600,000, they realized a $150,000 gain on the sale. Each spouse receives a $250,000 gain exclusion, so they do not owe any capital gains taxes on the sale of their home. They met the exclusion requirements by living in the house for at least two out of the past five years, and by not using the exclusion in the past two years.
Due to employment relocation, the couple sold their home at the current market price of $550,000, resulting in a $50,000 capital loss. Since capital losses from the sale of a primary residence can’t be used to offset other capital gains or carried forward into future years, the loss provides no tax benefit.
The couple benefited from the hot real estate market in their area and sold their home for $1.5 million, resulting in a $900,000 gain after living in the house for five years. Since they met the exclusion requirements, they can exclude $500,000 of the gain, leaving $400,000 subject to long-term capital gains taxes.
After living in the home for just one year to move closer to family, the couple sold their home for $900,000, resulting in a $300,000 gain. Lucky them, you might be thinking. However, since they did not pass the use and ownership tests, and they didn’t have to move because of an unforeseen circumstance, they are ineligible to use any of the gain exclusion. This leaves their entire gain of $300,000 subject to long-term capital gains taxes.
Real estate properties that you own and rent out either directly or through a partnership are considered investment properties. This type of capital asset receives capital gains treatment similar to other investments, such as stocks and bonds. Likewise, you don’t receive any sort of gain exemption like you do from your personal residence. The upside is you can use any losses to offset other capital gains and carry forward any remaining losses into future years. There are also income tax benefits to owning rental properties.
You might be thinking to yourself: If I have to sell my personal residence and it will result in a loss, why wouldn’t I just convert it into a rental property, and subsequently, sell it for a loss that can be used to offset other capital gains? This would be a great idea, but the IRS figured out this loophole and as a result, your basis in the property is adjusted to its fair value on the date you turn it into an investment property. In most cases, this wipes out your ability to realize any losses as your basis would decrease to its current market price.
No matter the outcome or reason, selling a home or purchasing a new home can be a very emotional and complicated decision. We recommend you speak with an advisor to ensure you’re making the best choices for your particular situation.
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Geoff has always enjoyed talking with people about finance, learning about their investments, financial strategy, and business sense. His interest only deepened with time, and what began as a hobby has now become a life-long passion, with an unparalleled passion for continuing education that makes him an expert in many subjects from traditional taxes and investments to business succession planning and executive compensation negotiations.
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