My parents have lived in the same house in eastern North Carolina for 45 years. That’s pretty remarkable when you consider that most Americans don’t stay: we move, on average, nearly 12 times in our lives.
Moving is particularly attractive right now. Record low mortgage rates combined with a limited number of homes for sale have created a sellers market: prices are skyrocketing and homes are selling almost as quickly as they can be listed. A local real estate agent told me that buyers go to extremes when purchasing property, including cash payments with limited or no contingency.
Sell your house
The hot real estate market makes homeowners wonder: is it the right time to move? Many factors go into these conversations – and taxes should be one of them. Here are some tax considerations when selling your home.
Capital Gain Exclusion is available to all qualified homeowners. Prior to 1997, homeowners were required to pay capital gains tax on the sale of their primary residence but could take time off buying a replacement home of equal or greater value. There was also a provision that allowed homeowners 55 and over to claim a one-time capital gain exclusion. That is no longer the case. Section 121 exclusion – on capital gains up to $ 250,000 of the gain on your income or $ 500,000 for married taxpayers – is available to all qualifying taxpayers who have owned and lived in their home for the five years prior to the sale. The years do not have to be consecutive: you can live in the house for the first and fifth years and still qualify.
You can convert a rental apartment into a main residence. You don’t have to buy a property to be your home forever, but if it works that way, you can still benefit from foreclosure. If you move to a room that was previously rented, the years do not have to be consecutive in the sense of the residence regulations. A quick warning: Congress is wise about taxpayers hoping to outsmart the system, so rules for recovering write-offs may apply. In addition, the period of time the property was not used as a primary residence can be considered “non-qualifying use” and the profit may be subject to adjustment.
You are not limited to a capital gain exclusion during your life. Capital gains exclusion applies to your primary residence, and while you may only have one of these at a time, you can have more than one in your lifetime. You can use the exclusion as many times as you qualify. And while you cannot claim a property as your main residence if you do not live there, if you move into your holiday home or investment property for two years – and otherwise meet the criteria – you can claim exclusion in the event of a later sale.
Outside of the exclusion, the “normal” capital gains rules apply to selling your home. That is, if you own your home for a year or less and then sell or otherwise dispose of it, your capital gain will be short-term and you will be taxed at your normal income tax rate. However, if you own your home for more than a year before getting rid of it, your capital gain beyond foreclosure will be long term. For 2021, the long-term capital gains rates for most investments are 0%, 15%, or 20%, depending on your taxable income. Special prices and limits may apply.
You cannot claim a loss of capital if you lose money selling your home. While it is true that you must tax capital gains from the sale of a personal residence, the opposite is not the case. You cannot claim a loss of capital when selling a home – no matter how much it hurts.
But what if you’re thinking of selling something other than your personal residence, like your vacation yurt or the hatch you’ve been keeping an eye on down the street?
Investor or trader?
The tax ramifications of buying and selling real estate besides your personal residence largely depend on whether the IRS sees you as an investor or a trader. These terms can be a little confusing as most taxpayers who see a flip will likely consider themselves investors while the IRS would characterize you as a trader.
What is the difference? There is no clear test of investing versus trading – it is based on facts and circumstances. The IRS looks at several factors, including motive and timing. Taxpayers who flip houses – especially apartment buildings – are typically treated as dealers or owners of real estate companies. But anyone who wants to benefit from it in the long term is often considered an investor.
Why does it matter? There are many tax ramifications, but the main focus is on characterizing the property. Traders, like other business owners, acquire inventory, not investments. When the flip is complete, the income is reportable on a tax return just like any other business. For non-corporate taxpayers, this means that it is listed on an Appendix C and taxes apply for self-employment. But it also means that related costs are deductible as business expenses even if they result in a loss.
However, if a taxpayer who buys and sells property is treated as an investor, the property – like the vacation home bought years ago – is considered an investment. The profit is taxed as capital gain, which usually means cheaper rates. However, if you lose money, the $ 3,000 capital loss limit applies. While investors are limited on spending, you can deduct mortgage interest and property taxes – according to the usual rules, of course. This makes writing the check to the local authorities for your vacation home a little less painful.
Remember: wins and losses don’t have to match. You don’t have to offset gains on stocks against losses on stocks or gains on bonds against losses on bonds. The same applies to profits from the sale of real estate. With a few exceptions, a win is a win. Therefore, consider real estate gains or losses in any year-end tax planning.
Speaking of tax planning, remember that the rules of buying and selling real estate can be complicated, especially if you mix partners or form units to own the properties. While I don’t think tax should be your main consideration when considering a Flip – let’s face it, we all secretly want to be Chip and Joanna Gaines – you should understand the basics before you begin. Better still, if you are planning on getting your hands dirty with a new real estate project, let your accountant do the heavy lifting.
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This is a weekly column by Kelly Phillips heir, the tax girl. Erb provides commentary on the latest tax law, tax law, and tax policy news. Every week, find Erb’s Bloomberg Tax column and follow her on Twitter at @taxgirl.