Home Selling: Will There be a Capital Gains Tax?

What is capital gains tax? A capital gains tax is applicable whenever someone sells an asset for a profit. The most common instances of capital gains come from the sale of property, stocks, precious metals and bonds. How are capital gains taxed? If you are ready to put your Eagle River area home on the market, you should know about the capital gains tax, if it will apply to you, and if so, ideas as to how to reduce the tax burden.

Though briefly explained here, it is always recommend to speak to a tax advisor or specialist regarding your specific financial and tax situation regarding a potential or actual home sale.

The Basics

When selling a personal residence, most homeowners can exclude up to $250,000 of any profits—or capital gains—from taxes. If you file your taxes jointly with a spouse, the exclusion rises to $500,000, in most cases. A stipulation is also written into the tax code that addresses the ownership and sale of a home by homeowners who may not be married. As long as each person separately meets the tests for the exclusion, each one may exclude up to $250,000 from the sale.

Capital Gains Don't Necessarily Equal Profits

A common misconception that many homeowners may have, is that the "profit" on the sale of the home is the capital gain. While that might seem to be the right answer after doing a little simple math—by subtracting the home's original purchase price from its current sales price—it is not always that simple. However, this may work to your advantage.

Capital Gains Explained

Wondering how to calculate capital gains tax? For tax purposes, a capital gain is the result of adding incurred closing and selling costs to the original adjusted purchase price of the property and then subtracting the selling price of the home. It is important to remember that the adjusted (tax basis) of the home may not be the same as the original price you paid for the home.

The adjusted original price of the home is defined as the original purchase price plus the cost of any capital improvements made during your ownership of the home. Capital improvements could include the addition of new rooms, a new kitchen, new landscaping or a new garage. Repairs to the home, such as paint, carpet and appliance switch-outs are not considered capital improvements. Generally, a capital improvement on property is anything that significantly enhances or improves the value of the home.

Now that the cost basis of the home has been calculated (by adding the original purchase price plus any capital improvements), to calculate the gain, also be sure and add any selling costs before calculating the capital gain. Selling costs typically include title insurance, commissions charged by a real estate broker, advertising costs, inspection fees, administrative costs, legal fees and escrow fees. Often, other closing costs such as prepaid mortgage interest and points can also be used for the calculation. Also falling under the category of deductible closing costs are any prorated property taxes that are attributed to you.

The Ownership and Use Test

An important element about being able to use the tax on capital gains exclusion is meeting the ownership and use test. This test states that prior to the sale of the home property, the home seller must have lived in the home for the equivalent of at least two out of the previous five years to qualify fro the exclusion. Even if you can't meet the stipulations of the ownership and use test as noted above, there are some situations in which you can still claim the tax exclusion.

Exceptions to the Ownership and Use Test

The exceptions to the ownership and use test mostly center around unforeseen circumstances. If you haven't lived in your home for two out of the past five years, a home seller may still be able to take advantage of a partial exclusion due to a change in employment status or as the result of divorce. Another circumstance that enables a partial exclusion is if a doctor urges a move to protect health, or if a significant life circumstance occurs—such as multiple births or a death in your family.

Second Homes Don't Enjoy the Same Exclusion

While the rules for excluding the capital gains tax on the sale of a primary home apply to those that occurred after May 6, 1997, those applicable to second or vacation homes were tightened as the result of a provision contained within the Housing Assistance Act of 2008. So how does capital gains tax work on second homes? Once these rules went into effect in January 2009, they stipulated that homeowners who used a home only part-time as a primary residence, as a rental property or a vacation home are only able to take a portion of the exclusion of capital gains tax.

The amount is calculated based on the amount of time a homeowner actually lived within the home as their primary residence. It is also worth noting that this time period applies back to January 2009 and not the five years as it does with a homeowner who owns only one property. If you have never established this second home (an Alaska log home, perhaps?) as your primary residence during the five years prior to its sale, you'll likely find yourself closed out of the exclusion completely.

How the Tax Cuts and Jobs Act Affects Capital Gains

The new Tax Cuts and Jobs Act preserved much of the original capital gains rules and regulations. However, the new act impacted everything from property tax deductions to home interest deductions. These new regulations combined with capital gains can make for more drastic numbers when it comes time to sell. 

The new law will limit how much a homeowner can deduct in property taxes to $10,000. This rule applies to all owners who itemize their taxes, regardless of whether or not they're single or married. While this will generally only impact those with higher property taxes, the limit can increase the amount of taxes a homeowner owes at the end of the year. If they're selling the home, the combined limit along with the total capital gains can make for a higher tax bill. 

In addition to limited property tax deduction, mortgage interest deduction for homes closed after April 1, 2018will be limited to $750,000. Prior to this, homeowners could deduct mortgage interest for up to $1 million. Considering home interest rates have been on the rise, those with ARMs may want to rework their math if they're planning to sell soon.  

While capital gains on real estate and its exclusions can be complex, arming yourself with information and knowledge now may assist you with making the correct decisions later.