It seems like a good time with booming real estate sales to talk about the potential taxation of selling a piece of property. To determine if there is any taxable gain, you must first understand your basis.
Your basis in the property is the purchase price, what you originally paid for the property, plus closing costs. Mortgage amount means nothing – that is just your method of financing, not your basis. Mortgages do not factor into your calculation. The presence of or lack of a mortgage impacts your cash flow but does not impact your tax situation.
To your original cost, you can then add any home improvement costs. Home improvements are structural changes such as a new roof, water heater, or deck. Repairs do not count – installing a new faucet to replace the old one that broke is repairing back to original use, not improving.
We recommend from the time you purchase your house until after a sale occurs, make sure to keep all home improvement receipts. Add together the original cost of your home, closing costs, and the cost of home improvements to get your total basis in your home.
The difference between your basis and the sales price after closing costs is your profit. Your profit is potentially what is taxable.
IRS considers a primary residence the home that you have owned and used as a principal residence for at least two out of the five years before the sale. When you sell your primary residence, you can exclude up to $500,000 of taxable gain or profit if your filing status is married filing jointly. For any other filing status, you can exclude up to $250,000.
For example, you purchase a house for $325,000 and pay closing costs of $6,000 in May 2009. Over the next few years, you added a deck and upgraded the kitchen with a total cost of $45,000. $325,000 + $6,000 + $45,000 equals a basis of $376,000. You have lived in the house since you purchased it in 2009 and are now ready to sell. You met the two out of five-year rule.
In May 2021, you now sold the property for $465,000 with closing costs of $33,000. $465,000 – $33,000 – $376,000 means a profit of $56,000. Since this is your primary residence and less than the exclusion amount, you will not need to pay taxes on any gain.
The primary residence has this exclusion written explicitly into the tax law. Other types of property do not have this exclusion.
Take the same numbers from the example above and change the scenario to a vacation home or camp that you own. This is not your primary residence, so that same profit of $56,000 would now be taxable. The sale would qualify for capital gains rate taxation and be taxed at the special capital gains tax rates.
The same calculation holds true if you are selling vacant land, a timeshare, or investment property. Calculate your basis, and the difference between that and the net selling price is your taxable amount.
There is one additional consideration if this is a rental property. Each year you have been claiming the rental income and expenses. One of the rental expenses you would be claiming each year is depreciation.
Depreciation takes your basis less a land value and divides it by the number of years to have an amount that you deduct each year on your taxes. For example, go back to the cost of $376,000 and assume that the land value is $56,000. The depreciable basis is $320,000.
IRS has a class life table that says a residential rental property would be depreciated over 27 ½ years. For commercial property, that class life table says 39 years. $320,000 divided by 27 ½ years indicates $11,636 a year in depreciation.
Using our previous example, from May 2009 to May 2021 is 12 years. $11,636 times 12 years is $139,632. From your basis of $376,000, you would subtract the depreciation of $139,632 to have a current basis of $236,368. Selling that property for $465,000 less, the closing costs of $33,000 less the basis of $236,368 calculates to a profit of $195,632.
The tax calculation would start with the amount of depreciation being recaptured at your ordinary or regular income tax rate. The amount of gain above that would be taxed at the capital gains rate. Using our example above – the gain of $139,632 would be taxed at ordinary income tax rates, and the remaining $56,000 would be taxed at the capital gains rates. Capital gains tax rates are dependent on your other current income and your filing status. Your capital gains tax rate will be zero, 15%, or 20%.
What if your basis in the property is greater than what you sell the property for? You have a loss. You must then determine if you have a tax-deductible or non-deductible loss.
If the property you are selling is personal property, the loss will be non-deductible. Are you selling your primary residence or a property that was used personally? If so, no deduction. Are you selling a rental property or investment property? If so, the loss would be deductible.
In the real estate market of today, we are seeing property being under contract quickly. The average length of time is less than 20 days. Often, we see individuals selling property for more than what they put it on the market for.
I am listening to several individuals wondering if they should get in on this real estate boom and thinking about selling their houses – and maybe they can do so for top dollar. Consider before doing that, where are you going if you do sell? With it being a seller’s market right now, those that want to buy may find themselves at a significant disadvantage. Even the rental market is struggling to keep up with the demand, and you may find it difficult to find lodging at a reasonable price.
We strongly recommend that if you sell a piece of real estate, you have an estimate done to determine the taxes that will be due because of the sale. To avoid paying the penalty, you may need to make quarterly estimated tax payments. We at Riverside Income Taxes are more than willing to assist in any way we can.
