Summer is traditionally a busy season for real estate. And if selling your home was part of your summer, you may have walked away from the closing table with a significant profit.
That raises an important question: Will you owe taxes on it?
For many homeowners, the answer may be no — or at least not on all of the gain. Understanding the rules now can help prevent surprises when it’s time to file your tax return.
The Primary Residence Exclusion
The IRS allows eligible homeowners to exclude up to $250,000 of gain from the sale of a primary residence. For married couples filing jointly, the exclusion can be as much as $500,000.
Generally, you must meet both an ownership test and a use test. During the five-year period before the sale, you typically must have:
- Owned the home for at least two years; and
- Used the home as your primary residence for at least two years.
Those two-year periods generally don’t have to be continuous or occur at exactly the same time.
Other rules apply. For example, you generally cannot claim the exclusion if you excluded gain from another home sale during the previous two years. In some circumstances, sellers who don’t meet the full requirements may qualify for a partial exclusion.
Your Profit Isn’t Simply the Sale Price Minus What You Paid
Here’s another important point: Your taxable gain may not be the number you think it is.
Calculating gain involves determining your home’s adjusted basis. That generally starts with what you paid for the property, but certain costs and capital improvements can increase your basis and potentially reduce your taxable gain.
Did you add a room? Replace the roof? Remodel the kitchen? Install a new HVAC system?
Records of qualifying improvements can become valuable when you sell. Certain selling expenses can also affect the calculation, so keep your closing documents as well.
What About Maryland Taxes?
For Maryland homeowners, the federal treatment of the sale matters at the state level, too. Maryland income taxes generally begin with income reported on your federal return.
That means gain properly excluded from federal income under the primary residence exclusion generally won’t become taxable income simply because you’re filing a Maryland return. However, if some of your gain remains taxable federally, it can also affect your Maryland state and local income taxes.
Maryland also has special withholding requirements that can apply when a nonresident sells Maryland real estate. If you’ve moved out of Maryland before selling a property here, that’s another reason to discuss the transaction with a tax professional.
What If It Was a Rental or Second Home?
The primary residence exclusion doesn’t automatically apply to every property you own. Vacation homes, investment properties and homes previously used as rentals can involve additional tax considerations, including depreciation and rules governing periods when the property wasn’t your primary residence.
The Lesson? Start Planning Now.
Gather your purchase records, documentation of major improvements and closing documents now rather than waiting until tax season.
A home sale can be one of your biggest financial transactions. Know what you made. Know what may be excluded. Know what you may owe.
JRJ is available year-round to help taxpayers understand how major financial decisions may affect their federal and state tax returns.