Capital Gains Tax on the Sale of Your Primary Residence (in US and Abroad)
Ines Zemelman, EAOct-15-2015
There is a section in the Internal Revenue Code that allows a sizeable exclusion from any profits realized by selling your primary home.
In the Internal Revenue Code is Section 121, which allows a capital gains exclusion of up to $250K ($500K if married filing a joint return) if the income is realized as a result of the taxpayer having sold his/her primary residence – the domicile in which one lives for the majority of the time.
To be eligible for this exclusion, you must have lived in your primary residence for at least a two year period out of the previous five years prior to the sale of your home. In addition, you cannot have claimed the §121 exclusion in the preceding two year period. You may also exclude gains on a changeover, such as a house being condemned or otherwise destroyed.
If property was located in the U.S. then is will be reported by the agent responsible for the closing transaction on Form 1099-S. If you sold your primary residence abroad, there will be no form 1099-S and taxable portion of the gain will be determined at the time of preparation of your U.S. tax return. The rate at which you are taxed will depend on the tax bracket into which you fall.
If there is any remaining profit after the exclusion has been applied, it will be reported on Form 1099-S and shown on your US tax return. If the entire gain is excludable, the closing agent is not required to file Form 1099-S, as per IRS Revenue Procedure 2007-12.
The capital gains tax rate for which you are liable will depend on your level of income. The capital gains tax rates for 2015 are as follows:
- Income of $0 - $9,225 to $37,449 – 0%
- Income of $37,450 – $413,199 – 15%
- Income of $414,200 and above – 20%
If your net investment income meets the threshold requirements of the NIIT (Net Investment Income Tax), your gains on the sale of your home will be subject to this tax as well. These threshold amounts are:
- Single and Head of Household - $200K
- Married filing a separate return - $125K
- Married filing a joint return - $250K
The exclusion can be used more than once, and the residency requirement of two years doesn’t have to be consecutive.
As long as you have lived in your home for a total of at least two years out of the previous five years, you have met the time requirement – even if you lived there a few months at a time. If you are away for a short period (vacationing, for example), this time is included in the two year requirement. Here is an example of how this would all work:
An elderly couple earns $500K a year, they own a primarily residence in which they’ve lived for 25 years. There is also a beach house that’s been in their possession for 15 years. Their plan is to retire in Florida, but before they move, they sell their primary residence for $600K. They are able to exclude $500K from their income, and they are required to pay the 20% capital gains tax and an additional 3.8% for the NIIT. Their total tax liability on the sale of their primary residence is $23,800. Two years after moving into their beach house, they decide to sell it for $300K, which is all excludable under §121.
There are extenuating circumstances which will be considered by the IRS when claiming this exclusion.
If your property is destroyed or condemned, this is considered an involuntary conversion. You may postpone your gain under §1033 and extend the two year residency requirement to include your new place of residence.
If you become incapacitated and are required to spend time in a care facility, you may still exclude the gain if your principal residence was used for at least one year out of the preceding five year period. The two year residency requirement must still be satisfied, though.
If you are a member of the US Military, you work as a Foreign Service personnel, or you are an intelligence officer on extended duty, you may suspend the ownership test for up to 10 years.
If you own more than one home, only your principal residence will be eligible for the exclusion. This is determined by the duration of occupancy in each home. In determining your primary residence, the IRS may also consider the address on your driver’s license, your voter or automobile registration, and the mailing address you use in your correspondence. You may also use undeveloped land for the exclusion if the land is adjacent to your primary residence and both the residence and the land are sold within a two year period. It’s important to note, however that the limit of the exclusion applies to both together – not to each one independently.
You may also apply the exclusion to the sale your mobile home, trailer, condo, or even your houseboat if you used either of these as a primary residence. If you have an investment in a retirement community, you will only qualify for the exclusion if you have equity in the property.
The §121 exclusion can not be used more frequently than every two years.
While the §121 exclusion can be claimed more than once, it can’t be used twice in a two year period. With this in mind, you may choose not to exclude income from the sale of one residence if you anticipate selling another residence with a higher gain potential. If you jointly own a property, you may claim up to $250K for your individual deduction against your share of the capital gains.
If you are married, you are eligible to claim up to $500K and exclude it from your capital gains.
In order to qualify for the $500K exclusion, you must meet the following requirements:
- You are married filing a joint return
- At least one spouse owned the residence for at least five years
- Both spouses meet the time requirement of living in the home for at least two years
- And neither spouse took a §121 exclusion in the two years prior to the sale of your primary residence.
If there was only one spouse that had lived in the house for at least two years, the qualifying spouse is the only one who can use the exclusion. Since it was only one spouse that qualified, the exclusion amount is limited to $250K instead of the $500K joint exclusion. If you and your spouse have separate homes, you may each exclude $250K for each home as long as the time requirements are satisfied.
There are specific rules in the event of death or divorce.
If your spouse dies before you sell your primary residence and you filed a tax return as married filing a joint return in the year of his/her death, you may add the years that your deceased spouse lived in the house as a primary residence. You will be considered to have had the property as long as your spouse unless you are remarried before the sale takes place. If both spouses die and there is a survivor, the $500K exclusion can be applied if the residence is sold within two years of their death.
If you and your spouse divorce and you wind up receiving the property in the settlement, you may combine your time of use and ownership with your ex-spouse’s time of use and ownership. If your spouse moves out before your divorce is final and you sell the property before a divorce decree, he/she may continue to claim and benefit from ownership and use provided that ownership interest is maintained and you continue to use the home as a primary residence.
If the entire time requirement is not satisfied at the time of the sale, you are still eligible for a prorated exclusion if other conditions are met.
If you are unable to meet the conditions of the time requirements due to extenuating circumstances, you will be able to claim a partial exclusion congruent with the time you have owned and resided in the property. ‘Extenuating circumstances’ includes health problems, change of employment, and a variety of other unforeseen circumstances that happens to you, a close relative, or another individual who shares ownership in the house.
For example. Imagine that you have lived at your house for one year and you are promoted and transferred. You are able to take up to 50% of your total biannual exclusion allowance. That means you can exclude $125K. If you sell your house for $140K, you will only be taxed on $15K.
Generally speaking, the IRS considers certain facts about each case to determine eligibility for the prorated exclusion. Luckily, the IRS draws some rather definite lines when it comes to the rule of employment changes. The rule states that if your new job is at least 50 miles further away from your home than the old job, you qualify for the prorated exclusion.
The health requirements are met if your relocation is primarily to have access to better healthcare or live with a family member. The health rule also applies to sick relatives. If you have to move to take better care of a sick family member, then you will qualify for the prorated exclusion.
‘Unforeseen circumstances’ refers to any change in your circumstances which makes the house in which you’re living unaffordable. This includes change of your financial situation, involuntary conversion, natural disaster damage, or a legal separation.
You must consider all expenses associated with the sale of your house in order to determine the gain realized.
The gain from the sale of your primary residence is calculated by deducting the selling expenses (real estate agent commission, broker fees, etc) and the adjusted basis of the house. Mortgage acquisition fees may not be excluded since these expenses are about obtaining a loan – not buying a house.
The adjusted basis of your home includes the purchase price and any home improvement expenses. ‘Home improvement’ expenses should not be confused with ‘home repairs’; home repairs cannot be included in the figuring of the adjusted basis.
Expenses that add to the adjusted basis include:
- Improvements that last for more than one year
- Expenses associated with restoration of damaged property
Expenses that take away from the adjusted basis include:
- Gains which were postponed from having sold a previous home prior to May 7, 1997
- Losses which were deducted from your ordinary income tax
- Casualty loss insurance payments
- Depreciation that was either claimed for rental purposes or a home business
- Any tax credits for home energy improvements that were claimed to increase the basis of the home
- Energy conservation expenses or public utility receipts which were excluded from your income
Postponed gains decrease the adjusted basis, because taxes have yet to be paid. Improvements must still be part of the home to increase the cost basis. For example, you may have painted the house five years ago and repainted it prior to the sale of your home. You cannot include the cost of the first paint job since it’s no longer part of the house.
It’s important to practice good recordkeeping, as you will be expected to justify increases to the adjusted basis. If you had filed Form 2119 to postpone gains from a previous sale, you should keep that form for at least three years in case you need it.
If you convert your residence into a rental property, the rules change.
If you convert your primary residence into a rental property, the tax basis at the time of the conversion will be the lower of either the adjusted base or the FMV (Fair Market Value). Typically speaking, if a primary residence was converted into a rental property just a few months before the sale took place, losses associated with making it a rental may or may not be deducted. It depends on whether or not profit was realized from your rental. Another consideration that will affect your profit and loss is whether or not there you were prevented by the lease from reoccupying the house for the duration of the lease.
If the house was purchased for resale rather than as a primary residence, then losses will be deductible – even if you occupied the residence for a period of time before the sale. If you are only living in your house to prevent damage from vandalism or to keep the house in tip-top condition for the ultimate sale of the property, it is assumed that you have no intention of living permanently in the home. Losses may also be deducted if you received a piece of real estate from a donor or as a gift and you have no intention of living in the residence that you plan on selling or renting.
If your primary residence is owned by a partnership whose partners happen to be married, then the entire gain must be reported and is not eligible to exclude under §121.
You may be eligible for only a portion of the exclusion once the time of qualified use and nonqualified use have been identified.
Your gain on the sale of your primary residence must be divided accordingly between the qualified use period and the non-qualified use period for the previous five years. Only the portion that is calculated as qualified use may be excluded from the sale.
For example, imagine that you bought a house for $400K in 2010. You rented it out for the first two years, then you moved in and used it as your primary residence for the years 2013 and 2014. You used a portion of the house for a home office and claimed total depreciation of $20K for two years. At the end of 2014, you moved out but you don’t sell it until January 1, 2016 for $626K.
Because the property was used as a rental for the first two years, only three years out of the five year period qualify for the exclusion. Because you deducted a total of $20K in 2013 and 2014 for depreciation, you must deduct this from your excludable gain.
- Realized Gain: $620K - $400K = $220K
- Gain – Depreciation = $220K – $20K = $200K
- Amount of Gain Which Can be Allocated as Qualified Use = 3/5x$200K = $120K
If you renounce your US Citizenship or long term resident status, you are no longer eligible to claim the exclusion under §121.
Ines Zemelman, EA is the founder of Taxes for Expats