By Attorney Daniel Vu
The general rule is, when selling a property, if you make a profit, the IRS will tax you on the profit. This is called a capital gains tax. To determine the profit you make, the IRS starts with the price you sold the property for and subtracts your “basis” in the property. Your basis is generally what you paid for the property. Next, IRS adjusts your basis by adding improvements and subtracting depreciation. This is also called your “adjusted basis.” But take an easy example, you buy a property for $100,000 and immediately flip it for $120,000. Your basis in the property is $100,000, you have no adjustments, and so your capital gains tax will be based on your $20,000 gain.
Now with the general rule understood, finally the answer to the question I get often, “Will I have to pay taxes when I sell my home?” The answer is usually, no. The reason being, most homeowners will qualify for an exclusion to this tax, referred to as a 121 Exclusion after the IRC code section that outlines the rule. The Tax Relief Act of 1997 enacted the current rule and replaced the pre-existing “once in a lifetime exemption.” Now, instead of the one-time exemption, you can actually take advantage of the exemption for an unlimited amount of times. You must simply own and live in the home as your principal place of residence for two of the past five years. The exclusion is limited to a $250,000 gain for an individual or a $500,000 gain for a married couple. But for most homeowners, fortunately or unfortunately, exceeding this limit (and thus having tax due) will never be a problem.
So the exclusion rule is simple, but of course I am not in the business of advising clients on the sale of their home. The follow-up questions I get are estate planning related. For example, “Do my kids have to pay the capital gains tax when they get the home at my death?”, “What if I gave them the property now?”, “What if I placed the property in a trust?”, etc. These questions take the simple rule to another level of complexity, but understanding the complexity is crucial to implementing someone’s estate plan. Call for a free consultation if you have questions about how capital gains might affect your estate plan.