Avoiding Capital Gains When Selling Your Home with the Home Sale Exclusion

In today's episode, Evon dives into the tax considerations when selling your primary residence.

Homes tends to make up a considerable portion of optometrists' net worth, and fortunately the IRS provides an exclusion for capital gains from selling your home.

Evon dives into the Section 121 home sale exclusion, the two tests you need to meet to qualify, certain exceptions to keep in mind, and planning considerations when selling a home that you've used as a rental property.

Have questions on anything discussed or want to have topics or questions featured on the show? Send Evon an email at podcast@optometrywealth.com.

Check out www.optometrywealth.com to get to know more about Evon, his financial planning firm Optometry Wealth Advisors, and how he helps optometrists nationwide. From there, you can schedule a short Intro call to share what's on your mind and learn how Evon helps ODs master their cash flow and debt, build their net worth, and plan purposefully around their money and their practices. 

Resources mentioned on this episode:

• IRS Publication 523 - Selling Your Home
• Schedule an Intro Call with Optometry Wealth Advisors!

The Optometry Money Podcast is dedicated to helping optometrists make better decisions around their money, careers, and practices. The show is hosted by Evon Mendrin, CFP®, CSLP®, owner of Optometry Wealth Advisors, a financial planning firm just for optometrists nationwide.

Transcript

Evon: 0:04

Hey, everybody. Welcome back to the Optometry Money Podcast, where we're helping ODs all over the country make better and better decisions around their money, their careers, and their practice. I am your host, Evon Mendrin, Certified Financial Planner(TM) Practitioner, and owner of Optometry Wealth Advisors. An independent financial planning firm just for optometrists nationwide. And thank you so much for listening. Really appreciate your time and attention today. And we're going to continue this real estate theme We're going to talk all about how the IRS views selling your primary residence, the home you live in, We're going to talk about how that changes when you turn your primary residence into a rental property or when you turn a rental property into a primary residence. So we'll dive into everything home ownership and what the tax outcomes are to selling your primary residence. And this is pretty important. I mean, when you think about the percentage of any optometrist net worth that's in their primary residence, it's, it tends to be pretty high. And there are all sorts of reasons we might need to. We might change houses. We might see our family grow and our homes are no longer appropriate for our family. We might buy a home that's affordable at one stage in our life and then as our living standard improves, our income increases, we can move into another home, better fitting that living standard. So, there's all sorts of reasons why we might move from one place to another. So let's go ahead and dive in. And I think it's helpful first of all, to just think about how the IRS views income, right? Generally speaking, all income from any source needs to be included in your gross income for tax purposes, unless it's specifically excluded by the Internal Revenue Code, the law of the land here. And generally speaking, selling capital assets or investment assets like businesses or real estate or investments in a taxable brokerage account at a higher amount than you originally bought it for, or that you originally invested into it produces a capital gain. That difference is a capital gain that should, again, generally speaking, be included on your tax return. Fortunately, Section 121 of the Internal Revenue Code provides a specific exemption for selling your primary residence for a gain. which can make sense, right? This isn't necessarily an investment. In fact, I would argue it's a form of consumption. Houses are, in a lot of ways, just money pits, right? There's, there's constantly money going into it. So, with this sort of exclusion, it makes sense when you're thinking about the, the primary residence, the place that you live in. So, let's 121, aka the Homesale Exemption. So what section 121 says is that when selling your main primary home, you can exclude up to$250,000 of capital gain from your income if you're single, or up to$500,000 of that gain if you file a joint tax return with your spouse. So if you're married and filing taxes jointly and you originally bought a house for$300,000 and then let's say 10 years later sold it for$600,000. You would have a gain of$300,000, right? It's increased in value above what you bought it for by$300,000. However, since the gain is less than$500,000 exclusion, you don't have to report the gain on your tax return as income. And there are two tests that you need to meet in order to qualify for this exclusion. There's an ownership test and a use test or a residential test. So, for the ownership test, you need to have owned this house for at least two years out of the last five years before you sell it. And for the use test, you have to have lived in the house as your primary residence, your main home, for at least two years out of the last five years before you sell it. So, for a married couple filing jointly, only one spouse has to actually meet the ownership requirement. So, maybe one, one spouse owned the house and then you got married and lived in it for two years. But both spouses need to use the home as their primary residence for two years to get the full$500,000 exclusion. Otherwise, it's cut in half. So, only one spouse needs to have owned it for two years out of the last five. But both spouses need to have lived in it for two out of the last five years in order to get that full$500,000 exclusion. Now, A lot of the times people ask, well, is it like literally the last two years before you sell it? And the answer is no, it doesn't have to be a consecutive two years in a row. It doesn't have to be a single block of time. You simply need to add up at least enough months or days over the last five years that add up to two years in order to qualify for these tests. And you can meet the ownership test and the use test during two different two year periods, right? So it doesn't have to match up exactly which two years you're using for each test. And there's a couple things to keep in mind. You can only have one main home at a time. So, you can't have a primary residence and then a vacation home that you spend some time at. There can only be one main home. Even if you're living, you know, three months, four months, five months out of the year somewhere else. and then spending the rest of your months another home, right? You can't use both of them for this exclusion. You can only use one. So which one is your primary home, your main home? Well, if you own or live in more than one home, there's a facts and circumstances test. So there's going to be a bunch of factors like where do you receive mail? Where do you spend the most time? Where is your voter registration say you live? If it's near where you work, where you bank? You know, where are your recreational religious memberships? Like, is your church and other clubs that you're a part of next to one house and nowhere near to the other? So the IRS is going to go through all these different factors to figure out which one is the primary residence, but you can only have one. Secondly, you can only use this exclusion once every two years. So if you sold the house and took the exemption within the last two years, well, you have to wait for another two years. In order to take it again, right? So this is something you can do once every two year period. You also might be eligible for a partial exclusion of the gain. So, there's several situations that basically end up as like surprises in your life, that can give you a partial exclusion of the gain if you didn't meet the full test. So for example, there's work related moves. if you had to transfer to a new job and a new work location, you have to work at this new work location, there's a certain amount of miles that has to meet. There's like a, there's a, a, essentially a mileage requirement in order to get a partial exclusion, health related moves. Other unforseen eventsts like houses getting destroyed or having a casualty loss from a natural disaster or something like that. death and divorce, birth of two or more children from the same pregnancy is an interesting one. So twins or triplets, you know, those are sort of these unexpected events that might make this house no longer appropriate, right? So specific cases where you can get a Partial exclusion from the gain, even if you don't meet the full five and two year rules. So how do we calculate the gain, right? how do we calculate it appropriately? You know, if you think about any other capital or investment asset, you have a cost basis in this investment. So it might be your original. investment in that investment or your own principle. This is the after tax amount that you've already put into the investment. You buying a certain mutual fund for a hundred dollars in a taxable brokerage account is a good example. Like that a hundred dollars is your basis and anything above that would be the gain. And so with your home, your basis is your original purchase price, plus or minus certain adjustments. So you can take your original purchase price plus improvements to your home, right? So capital improvements, IRS publication 523 has a pretty nice list of different improvements to think about. So it's additions to the house, right? Additional bedrooms, bathrooms, decks, garages, things like that. landscaping, fences, swimming pools, You know, additions or enhancements to plumbing or like central systems like ACs, new ACs, or heating systems. All of the costs of these improvements, not only hopefully improve the property value, but also add to your cost basis as well. So it's really important to keep a documentation of all these different improvements that you're doing to your house. Keep track of all of the invoices and receipts of all these things that you're doing over the years. Certain fees and closing costs like legal fees, recording fees, title insurance, those things can increase your basis as well. This doesn't include regular repairs or maintenance to the house. So unless it's a part of a really big remodel or restoration, you know, the core thought is that it doesn't include anything that's. that has a useful life of less than a year. So all the basic, day to day maintenance and repairs and things like that, those don't impact your basis. So you can calculate your adjusted basis, right? Your original purchase price plus all these increases. You look at the amount that you sell the house for and that difference between the two is the gain. Now what if you receive the house as a gift, right? What if a family member gifted the property to you? Well, you'll essentially use the prior owner's cost basis on the date that you received it, plus your own adjustments or improvements to the property, right? So whatever the basis was with the previous owner, that essentially passes on to you. What if you inherit the property, right? So what if a family member passes away and you inherit the property from that family member? Well, when someone dies, the cost basis will receive a step up, meaning that the cost basis will then become whatever the fair market value is at the, at the owner's death. So if the value of the property is higher than the cost basis, then essentially that whole gain is erased. Although if the market value is lower than the cost basis, then it steps down. Which is a pretty unfortunate circumstance, but oftentimes, that cost basis is going to get a step up, which essentially erases the capital gain when you inherit it. there are special considerations if you're married and you jointly own the property with your spouse, right? So you're essentially inheriting your spouse's property. portion of that ownership. if you are in a non community property state, for example, potentially only that spouse's ownership receives that step up. However, if you live in a community property state, perhaps the full value of the property steps up. So there's some special considerations to keep in mind when you're married and you are inheriting that ownership from your spouse. And there are also some certain exceptions to these rules, you know, for example, if you are separated or divorced, there's some exceptions on meeting these rules if you're a surviving spouse, if your spouse had passed away, there's certain exceptions to the rules where if you haven't remarried when settling the house, you can actually include any time your late spouse owned and lived in the home, even if it was without you, when trying to meet both the ownership and the resident and the use requirement and the use tests. You can also use the full$500,000 exclusion amount if you sell your home within two years of the death of your spouse and you haven't remarried. And you haven't taken that exclusion already within the last two years, two tests with that earlier caveat I just mentioned. additional flexibility there within the first two years after your spouse passes away. there's exclusions for service or intelligence or Peace Corps personnel. When you're on qualified official extended duty. There's certain exceptions to 1031 exchanges where 1031 exchanges can actually disqualify you from taking the exemption. If you bought the home, if you acquired the property in a 1031 exchange and you sold it within, within five years after doing that. So let's say you had a rental property. Let's say you had a commercial rental property. You 1031 exchanged it into a residential rental property. And then two years later you, Moved into it. And two years later sold the property. Well, you wouldn't meet this test, right? So, so if you're going to do this for a 1031 exchange. you had to have owned the property for five years after that, as well as met that two year living requirement, use requirement. So there's important considerations here with 1031 exchanges, and there's several important issues when calculating cost basis appropriately, especially when, when turning a rental property into a residential that you're living in. So please work closely with your tax professionals here. So where do you report the sale of the house? So even if it's fully excluded and there's no, And, and there's no income to report. You do have to report the sale on Form 1099-S Proceeds From Real Estate Transactions. You have to report that capital gain, even if it's excludable and if it's not excludable. So if there's any, so if there's more than those exclusion amounts, then you have to use Schedule D and Form 8949, where you're gonna report other capital gains and losses from selling other assets. And so this is all if you are selling only your primary residence, right? There's no rental activity outside of the 1031 exchange we just mentioned. What if you're doing this and it's involving a rental property? This is where it starts to get interesting. So if you're taking your primary residence, right? So, it's your primary residence first, and then turning it into a rental property. How does that work? So if it's your primary residence first, and then you turn it into a rental property, you can still exclude the capital gain up to those limits,$250,000 or$500,000, if you meet the criteria. Meaning you've owned and lived in it within two years, out of the last five years. So you can essentially buy a house, live in it for two years as your primary residence, and then for the next couple years, rent it, and then sell it before the fifth year, and you'll still fully qualify. And you meet the criteria, so the full gain is going to qualify for that exclusion. Remember, it's three years later to the day, right? So you don't want to rent it all the way up until just before that three year period and then try to sell it. Because once you pass that three year period, it's now a rental, right? That exclusion is gone. So you need to be very careful about that. But there is the potential to, but there is the potential to move on from a primary residence and then rent it for a couple years. and then sell it and you're able to get that full exclusion. However, something to keep in mind is that when you are renting the house, you're going to be taking depreciation deduction. And even though you qualify for this home sale exclusion, you still need to deal with depreciation recapture. You can't get away from that. Even if you choose not to take the depreciation deduction, the IRS is going to assume that you did when calculating the depreciation recapture. So there's really no reason not to take it. And depreciation recapture is going to tax the amounts that you took as depreciation as ordinary income up to a maximum of 25 percent tax rate. Whereas long term capital gain tax rates are going to be zero or 15 or up to 20%, right? so that's a good reminder that depreciation isn't necessarily free dollars, right? You're not getting rid of that capital gain. So on that depreciation amount, you're still going to have to deal with that recapture at a higher tax rate, up to 25%. So that's if you turn a primary residence into a rental. But what if you take a rental property, so you have this rental property, and then live in it, right? And then turn it into your primary residence? How does that work? Because I would imagine a lot of you might own rental properties and are thinking about, well, maybe you're hearing a loophole around this whole, Capital gains issues. Well, unfortunately not, it's actually much different if you take a rental property, which was a rental property first, and then turn it into a primary residence. When it's rented first, the entire gain is not unfortunately eligible for the exclusion. The way that that works is that the amount of time that it was a rental property is considered non qualified use. And you can't take the exclusion for that time it was a rental property. You can only take the exclusion for the amount of time you lived in it as your primary residence, which really makes sense, right? So you take the amount of years that you lived in it as your primary residence divided by the total amount of years it was owned and that's the percentage of the capital gain that's eligible for the exclusion. So let's say as an example, you own a rental property for five years and then you lived in it for five years. So you've owned it for 10, but only those five years you lived in it are eligible for the exclusion. So in this case, only 50 percent of the capital gain is eligible for that exclusion. Now it's also important to keep in mind that this is true from January 1st of 2009 and on, due to the Housing Assistance Act of 2008. So, if you own a rental before January 1st of 2009, so let's say you've owned, maybe you've owned it for quite a long time, all of that time before 2009 is considered qualified use time. So it does qualify for the exclusion. It's only that rental time from January 1st, 2009 and on, that's going to be non qualified use time. And what's interesting about that is that even if all of the growth of the property value happened during the years it was rented, The calculation assumes that it, that all of that growth happened evenly while you owned it. So, for example, if you rented it for five years and then you lived in it as your primary residence for two, even if all of that growth in the property value happened during that five years you rented it, and it didn't grow in value at all during the two years you lived in it, you still get to take roughly 28.6 percent of that capital gain, as eligible for the exclusion, the IRS still views portions of that growth as happening during those two years you lived in it. Which leads to other interesting ideas like moving out of your primary residence into a rental and then living in that rental for two years and then selling it to exclude certain percentages of that capital gain. And you might even consider r moving back into your original primary residence within three years and then selling that to get the full exclusion on those capital gains. As long as you're doing this every two years and meeting eligibility. So if you're entirely flexible about where you live, And you're willing to sort of hop back and forth across your different properties, like this is some interesting, interesting opportunities here. Personally, I wouldn't do it. That sounds like a terrible way to live. I'm all about being rooted down in one place, but, but some people might be perfectly fine with that. And that all being said, we're still kind of scratching the surface here, right? So there's additional considerations if you own a home and live in it, but use parts of it for business use, or if you're renting parts of it, there's certain considerations there. there's all sorts of other details we haven't really gone into. All that being said, your primary residence that you live in, generally speaking, has a nice, Tax exclusion when selling it and benefits from this section 121 exclusion, and there's certain considerations when either turning your house into a rental property, or more importantly, turning a rental property into a primary residence. As with all things, whenever you're planning to purchase a big asset, you know, whether it's a business, whether it's a commercial real, a rental real estate property, whether you're planning to sell a primary residence, just talk with your professionals, right? Talk with your financial advisor, talk with your tax professionals and plan ahead of time. Think about your future moves. What are the life events coming up that might send you off to a new house, living somewhere else? What do you want to do with that old property? Do you want to pull that equity and put it into the new house? Do you want to use that as a rental? Do you want to use it as a rental? Do you want to use it as a rental for only a couple years or do you want to turn it into a permanent rental, The farther ahead you can plan and think these decisions through, the farther ahead you can talk to professionals and plan out all of the financial and tax impacts of those decisions. Hope you enjoyed the episode. If you have any questions on any of these topics, or if you have ideas for future episodes or have questions you'd like to get answered on future episodes, reach out. You can reach me at podcast@optometrywealth.Com. You can also check out all the links and resources I mentioned here in the episode in the show notes, which you can find at the education hub on my website, www.optometrywealth.Com. And while you're there, feel free to check out all the other episodes and resources we put together. As well as, feel free to schedule a no commitment Introductory call, and we can talk about whatever's on your mind financially, real estate taxation or not, and I can talk about how will I help optometrists all over the country navigate those same decisions and more. So with that, we will catch you on the next episode. In the meantime, take care.