Buying or selling a home is one of the most significant financial transactions many individuals engage in. The authors examine the various ways in which CPA financial advisors can guide different kinds of potential home buyers and sellers through the process and the myriad tax implications of home sales and purchases. Changes made by the Tax Cuts and Jobs Act of 2017 (TCJA) probably won’t be a deal breaker for many prospective residential sales or purchases, but these changes should be considered and are discussed throughout this article.
According to the National Association of Realtors, the median sales price of an existing single family home was $267,500 in May 2018, representing a major financial event for the average individual. CPA financial advisors can provide valuable suggestions to home sellers during such transactions, helping them lower the resulting tax obligation or avoid taxation altogether.
CPA financial advisors can provide valuable suggestions to home sellers, helping them lower the resulting tax obligation or avoid taxation altogether.
Furthermore, selling a home opens up many new questions, depending upon individual circumstances. A young couple might want a larger house for a growing family, while retirees may wish to downsize. Instead of buying, many who have just sold a home may decide to rent instead. A knowledgeable advisor can offer insights that lead to informed decisions.
Exclusion on Gains from Home Sales
Financial planners may find that some individuals believe that gains on a home sale can be deferred by buying a new one. Indeed, that was the law in the past: After selling a home, taxpayers had up to two years to reinvest the sale proceeds in a home that cost as much or more as the one that was sold and defer the tax on any gain. In addition, once taxpayers reached age 55, they could take a once-in-a-lifetime tax exemption on gains (including deferred gains) of up to $125,000. That tax treatment expired, however, with the passage of the Taxpayer Relief Act of 1997. Now, home sellers can exclude (not defer) up to $250,000 of housing profits from capital gains tax; married couples who file a joint tax return can exclude up to $500,000 of housing gains. In the case of a married couple, either or both spouses can own the property, and the same individual or couple can claim these exclusions repeatedly, not just once in a lifetime. This rule was not changed by the TCJA.
Several conditions must be met in order to earn the $250,000 or $500,000 tax exclusion. The exclusions apply only to sales of a primary residence, that is, the main home where the seller has lived. Selling a vacation home or investment property does not qualify. A primary residence can be any dwelling, however, including a condo, a co-op, a mobile home, a recreational vehicle, or even a boat. As long as it has sleeping, cooking, and toilet facilities, the place where the seller has spent the most time can qualify for these exclusions on a profitable sale.
The seller must have owned the home and used it as a primary residence for at least two of the five years before the sale. The two years can be interrupted. Suppose, for example, that Arlene bought a house for $300,000 in May 2013. Arlene then lived there until June 2014, when she relocated to another state. In December 2016, Arlene moved back into the house. In July 2018, Arlene sold the house for $400,000; she had owned the house since May 2013, so she met the two-year ownership requirement. During the five-year period prior to the sale, Arlene used the house as her primary residence for 14 months (May 2013 to June 2014) and then for 20 months (December 2016 to July 2018). Therefore, she passed the two-year (24-month) residency requirement as well. Arlene can exclude her $100,000 gain from tax because it is less than the $250,000 maximum exclusion. If her gain had been $280,000, she could take the full $250,000 exclusion and would owe tax on the $30,000 excess gain (probably a 15% or 20% tax on long-term capital gains and perhaps a 3.8% surtax on net investment income).
Home sellers can claim the $250,000 or $500,000 tax exclusion multiple times, with no limit on how often they use the tax benefit; however, these exclusions usually cannot be claimed within two years. In the previous example, Arlene claimed an exclusion for a house sale on July 31, 2018. Therefore, if she sells another house before July 31, 2020, she probably cannot claim any tax exclusion on that sale.
Some exceptions do apply in cases of poor health, job changes, or unforeseen circumstances. A sale due to poor health after 12 months of ownership and occupancy, for example, could qualify for a $125,000 or a $250,000 tax exclusion (50% of the maximum amounts) because the sale occurred halfway through the required two years. Such exclusion amounts might cover all or most of the gain in a short time period.
Impact of Business Use
Selling a house that was used as a rental property as well as a main home adds complexity to the capital gain exclusion rules. Various possible scenarios exist on such partial business use of a primary residence, with myriad tax treatments depending on when the business versus personal use has occurred. Generally, a home seller must reduce the basis of the property by the amount of depreciation allowed before determining any gain on the sale. Gain attributable to depreciation may be subject to the 25% unrecaptured Internal Revenue Code (IRC) section 1250 gain tax rate and possibly to the 3.8% net investment income surtax.
To continue the above example, suppose that when Arlene moved out of her house from June 2014 to December 2016, she rented it to a tenant. Arlene cannot exclude the part of the gain on the 2018 sale equal to the depreciation she claimed or was allowed to claim while her house was a rental property. She also must calculate the amount of her gain attributable to the period of non-qualified (rental) use, as described below, which may reduce her tax exclusion.
It is impossible to know when a house will be sold or for how much, so homeowners should track basis carefully from the first day of ownership.
Selling a Vacation Home
As mentioned, the $250,000/$500,000 capital gain exclusions apply to sales of a primary residence. Profitable sales of vacation homes are fully taxed.
One possible way around this limitation is to sell a primary residence and use the exclusion, then move into a vacation home full time. After two years, the former vacation home will qualify as a primary residence and another exclusion. The tax savings on such a transaction, however, have been reduced by the Housing and Economic Recovery Act of 2008. Vacation homes (and rental properties) that are converted to primary residences and then sold must allocate ownership time between “qualified” and “nonqualified” use after 2008.
For example, Charles and Diana have a beach house they have owned since 2003 where their family spends a great deal of time in the summer. In December 2016, they sell their long-term primary residence and report a $400,000 gain on the sale, fully covered by the $500,000 gain exclusion for couples filing jointly. Immediately after the sale, they move into the beach house and live there full time. They can wait for two years and then sell their beach house, using the capital gain tax exclusion once more, but the amount excluded is dictated by the 2008 legislation. They had eight years (2009 through 2016) of non-qualified use of their beach house when it was a vacation home. Assuming a purchase date of January 1, 2003, and a sale date of December 31, 2018, they will have owned the beach house for 16 years. Half of that time was nonqualified, so half of the gain on the sale would be taxed and half (up to $500,000) would be excluded.
As explained above, home sellers generally qualify for a capital gain tax exclusion of up to $250,000/$500,000 on the sale of a home owned and occupied for more than two years. That exclusion often results a tax-free sale. Some homes, though, sell for apparent profits that exceed those amounts. It is still possible to reduce or even eliminate tax on such sales by proving a substantial basis in the property. For example, Fred sells his home of many years for $600,000, qualifying for the $250,000 exclusion. If Fred’s basis in the home is $220,000, Fred will have a $380,000 gain. After using the $250,000 exclusion, he will only owe tax on the balance, $130,000. If Fred’s basis is $410,000, however, he will have a gain of only $190,000 on a $600,000 sale, and the tax exclusion would make the sale tax free. Therefore, increasing the basis of a primary residence can generate tax savings. It is impossible to know when a house will be sold or for how much, so homeowners should track basis carefully from the first day of ownership.
Initially, a home’s basis is the purchase price. Some of the costs associated with the purchase can be added to the basis, including legal fees for the title search, survey fees, and transfer taxes. All records of the home purchase, such as the closing statement, should therefore be retained indefinitely. The cost of home improvements can be added to the home’s basis. Such improvements are changes that increase the home’s value, prolong its useful life, or adapt it to new uses. Numerous projects qualify, from building a deck to installing a fence to putting in storm windows; however, routine painting, repairs, or maintenance will not boost a home’s basis.
The sidebar, Home Improvements that Increase Basis, provides some examples of improvements that increase basis in a residence. The IRS notes that home sellers can include repair-type work done as part of an extensive remodeling or restoration job. For example, replacing broken windowpanes is a repair, but replacing the same window as part of larger project is an improvement.
A home seller who can exclude all of the resulting gain from tax does not have to report the sale on a federal income tax return. Any gain that cannot be excluded, however, must be reported on Schedule D (Capital Gains and Losses) of IRS Form 1040. Any loss on a sale of a residence will not generate a capital loss that can be claimed on a tax return. For details on how to report gain or loss, see the Instructions for Schedule D and the Instructions for IRS Form 8949.
Points at Closing
Homebuyers who take out mortgages often pay points at closing equal to 1% of the mortgage balance to reduce the interest rate on the loan. When those points are paid on a loan to buy a primary residence, the homebuyer might be eligible for a current tax deduction, assuming certain requirements are met.
Some outlays for points, however, generate small annual deductions over the life of the loan (e.g., vacation home purchases, refinanced mortgages). If any undeducted points remain when the house is sold and the mortgage is paid off, those remaining points can be deducted in the year of the sale.
Taking the Next Step
Home sellers must make new housing decisions. Is it better to buy a new home or to rent one? One factor to consider is the comparable cost. The higher the annual rent-to-purchase-price ratio in a given area, the greater the financial advantage of buying a home. For example, Heidi can buy a home she likes for $300,000, or she can rent a similar house in the neighborhood for $1,000 a month, or $12,000 a year. In this scenario, the annual rent-to-price ratio is $12,000 to $300,000, or 4%. In another state, Kirk also finds a desirable $300,000 home. In that area, a similar home rents for $1,500 a month; thus, the annual rent-to-price ratio for Kirk is $18,000 to $300,000, or 6%. Kirk might do better to buy a home; Heidi could consider a reasonably priced rental.
Calculating the Costs under the TCJA
The buy-versus-rent decision goes beyond the costs mentioned above. Homeowners typically qualify for tax benefits that are not available to renters. As explained above, a profitable sale of a primary residence may generate little or no tax liability. Before the passage of the TCJA, several tax advantages could generally be claimed yearly by homeowners, most notably including the deduction for state and local taxes and the mortgage interest deduction (including home equity loan indebtedness generally). The moving expense deduction was available, if appropriate.
The TCJA reduced or eliminated these tax breaks for 2018 through 2025:
- The deduction for state and local taxes has been limited to $10,000.
- The mortgage interest deduction has been retained, but the maximum amount of indebtedness used to calculate the deduction has been reduced to $750,000 (down from $1 million).
- The deduction for home equity loans has been eliminated, unless the loan proceeds are used to “buy, build, or substantially improve the taxpayer’s home that secures the loan” (see IR 2018-12, Feb. 21, 2018).
- The moving expense deduction is eliminated.
The doubling of the standard deduction and the elimination of the miscellaneous itemized deduction, as well as the tightening of the casualty loss rules, may reduce the tax advantages for many homeowners.
Also, although not specifically directed to home ownership, the doubling of the standard deduction and the elimination of the miscellaneous itemized deduction, as well as the tightening of the casualty loss rules, may reduce the tax advantages for many homeowners. Therefore, the choice between buying and renting will also depend upon the amount of tax savings a buyer can expect. A buyer who will take the standard deduction on a tax return instead of itemizing deductions, for example, will not realize any tax savings from the mortgage interest and state and local tax deductions.
In 2018, the standard deduction is $12,000 for single filers and $24,000 for married couples filing jointly. (Prior to the TCJA, these amounts were $6,350 and $12,700.) Taxpayers who will not spend this much on the total of their mortgage interest payments, state and local taxes, and charitable donations will take the standard deduction and thus will not benefit from the annual tax deductions available to homeowners.
Furthermore, even those taxpayers who itemize deductions may want to calculate the actual tax savings they can expect. Suppose that Matt and Nora have a total of $26,400 in itemized deductions in 2018. If they are in the 12% tax bracket, their tax savings from home ownership would be $288, or 12% of their $2,400 in additional deductions. If they have $200,000 of taxable income, however, they would be in the 24% tax bracket, and their yearly tax savings from home ownership would be $576. The exact amount of tax savings will of course differ from taxpayer to taxpayer depending, but in general higher incomes and higher tax brackets will lead to greater tax savings from home ownership.
Therefore, young people with modest incomes may be better off renting their home. The same might be true for retirees who have sold their homes if their income has dropped. On the other hand, people in their prime earning years might do better to buy a home, assuming the annual rent-to-purchase-price ratio is favorable. The tax savings available to high-income homeowners can also be a considerable factor in favor of home ownership.
Deducting Home Mortgage Interest
With the median home price well over $200,000, most homebuyers use mortgage loans to complete a purchase. Interest on loans used to buy, build, or substantially improve a home is typically deductible. In fact, taxpayers can deduct interest on loans secured by two homes. For example, suppose Ida owns a condo apartment in the city and a beach house, with mortgages on both. Ida can probably deduct all the interest she pays on both home loans in 2018, assuming that the total of these two loans do not exceed $750,000.
Now suppose that Ida gets married in 2019 and her husband Ivan also owns a home with a mortgage. The couple plans to file a joint income tax return for 2019 and future years. In this situation, they can deduct only the interest on loans secured by two of their homes. Therefore, they will likely choose to deduct the interest on the two loans with the highest interest payments during the year.
Loans taken out after October 13, 1987, that are used to buy, build, or substantially improve a home are known as “home acquisition debt.” Other loans, also secured by a home but not necessarily used for any specific purpose, are considered “home equity debt.” Beginning in 2018, the TCJA provides that interest paid on home equity debt is no longer deductible unless the loan proceeds are used to “buy, build, or substantially improve the taxpayer’s home that secures the loan.” Previously, interest on such debt was tax deductible for balances up to $100,000 ($50,000 for married taxpayers filing separately), even if used for other purposes, such as paying off credit card debt.
The deduction that was formerly available for mortgage insurance premiums expired at the end of 2017. It was not extended by the TCJA.
For home acquisition debt incurred after December 15, 2017, and before 2026, the interest paid on balances up to $750,000 of debt ($375,000 for married taxpayers filing separately) is deductible. Prior to this change made by the TCJA, these limits were $1 million and $500,000. Suppose, for example, that Tom has an $840,000 balance on his primary home mortgage, and a $380,000 mortgage balance on his vacation home, for a total of $1,220,000 in home loans outstanding. Tom’s itemized mortgage interest deduction on Schedule A would be capped at the interest paid on $750,000 of this debt.
Deducting Property Taxes
Homeowners can generally itemize the state and local property taxes paid for their home or homes, but beginning in 2018, the TCJA provides that the amount of this deduction is limited to $10,000 each year. Also, there is no limit on the number of homes covered by this deduction, but deductions will no longer be allowed for taxes paid if the residences are outside of the United States. No mortgage interest itemized deduction is allowed, however, if the home is a full-time rental property. The deduction must be taken for the year in which the taxes were paid. For example, if Vicki owes a property tax payment on her home that is due in February 2019, but is paid in December 2018, she can take an itemized deduction for that amount on her 2018 return.
Some states, such as New York, have proposed workarounds to preserve the unlimited federal deduction for state and local taxes paid by its residents by creating local charitable funds under which 95% of a taxpayer’s contribution to such funds would qualify for a tax credit to be applied against the contributor’s state and local tax liability. However, the IRS takes a dim view of these attempts, noting that it will apply a “substance over form” analysis to these state plans (Notice 2018-54, IRB 2018-24, 750).
A Major Event
Leaving one home for another is a major life event, and as such has major tax implications. By making individuals aware of the facts surrounding such issues, CPA financial advisors can help taxpayers make the right financial choices when buying, selling, or renting a home.
Checklist for Housing Transactions
Selling a Home
- ☐ Use the home sale exclusion for gains up to $250,000 ($500,000 for joint filers).
- ☐ Test for eligibility. Meet two-out-of-five-year tests for ownership and use.
- ☐ Use the exclusion serially every two years. One tactic is to sell a principal residence now, then make a vacation home into a principal residence and sell it after two years.
- ☐ Recognize “unforeseen circumstances” to allocate the exclusion for the portion of use that is less than two years.
- ☐ Where home values are declining and the residence is not selling, consider converting to rental use so that future declines can be deductible.
- ☐ Determine whether any undeducted points remain when the mortgage is paid off upon the sale of the home; this generates a deduction in the year of the sale.
Buying a Home
- ☐ Calculate the cost of buying a home versus renting a similar place.
- ☐ Determine the impact of home costs on income taxes (e.g., mortgage interest, points, real estate taxes) and adjust withholding and estimated taxes accordingly.
- ☐ Consider making energy-saving improvements. A federal income tax credit for solar panels is available through 2021. Other energy-saving improvements also may earn tax credits.
- ☐ Determine whether there are any state-level tax benefits (deductions, credits, sales tax reductions, financing options) for energy-saving improvements.
- ☐ Keep good records of capital improvements for basis purposes.
- ☐ Recognize a homeowner’s ability to rent the home for up to 14 days each year and receive tax-free income.