Tim Sullivan

Tim Sullivan

Editor’s note: This column was originally published June 13, 2021.

The residential real estate market continues to be extremely strong. Zillow, the online real estate data company, reported nationwide year-over-year price increases through the end of April 2021 of 11.6% for the middle price tier of homes. Similar price increases have been seen in Columbia, although some local realtors say it has been more, especially for certain market segments. Regardless, many seller’s have reaped a financial windfall selling their homes and may be concerned about tax consequences related to this newfound fortune.

First, consider a few noteworthy definitions. A homeowner’s “basis” is what they paid for the home at the time of purchase. The “adjusted basis” is the price paid for the home plus or minus any “adjustments” that change the basis. When a homeowner eventually sells the home, the net sales price minus the adjusted basis equals the “gain” or “capital gain” on the home. Fortunately, back in 1997 Congress passed the Taxpayer Relief Act which provides an exclusion large enough for most homeowners to avoid paying taxes on the gain realized from the sale of their primary residence.

The maximum exclusion a single homeowner is eligible for is $250,000 ($500,000 if married filing jointly). To qualify for this exclusion, homeowners must meet the Eligibility Test, a six-step requirement outlined in IRS Publication 523.

Step 1 outlines two automatic disqualifiers. If the home was acquired in a like-kind exchange (1031 exchange) in the last 5 years or the taxpayer is subject to expatriate tax, the exclusion does not apply.

Step 2 is the ownership test. An individual must have owned the home for at least 24 months out of the five years leading up to the sale of the home. For married couples, only one spouse must meet this ownership test.

Step 3 is the residence test. The homeowner must have used the home as their primary residence for at least 24 months of the five years leading up to the sale of the home. The 24 months can be split into any time frame and does not have to be a single block of time. However, for married couples filing jointly, both spouses must meet the residency test to qualify for the full exclusion.

Short absences from the home or vacations will not negatively affect your residency. For example, if an employer required their employee to travel out of the country for two months, the employee would still meet the residence test over those two months.

In addition, individuals who are unable to care for themselves at home because of a physical or mental condition are only required to live in the home for 12 months over the preceding five years and can use any time spent in a care facility such as a nursing home or other licensed care facility to meet the 24-month residency test.

Step 4 is a look-back requirement. This rule states that a homeowner will not be eligible for the exclusion if they have sold another home during the two-year period before the date of sale of the current home, or it they did sell a home, they must not have used any exclusion on any gain that may have been earned.

Step 5 lists multiple exceptions to the other eligibility rules. Guidance is outlined for divorced or widowed homeowners, sales involving vacant land next to a home, service members on extended duties, and other specific situations affecting eligibility for the use of the gain exclusion.

Step 6 is the final determination of eligibility. If an individual meets the ownership, residence, and look-back requirements, then they meet the Eligibility Test.

Many sellers will pass these qualifications with flying colors and be able to use the proceeds of their home sale without tax ramifications. However, homeowners who do not pass the Eligibility Test may still qualify for a partial exclusion of gain if the reason for the home sale is mainly because of a change in workplace location, a health issue, or an unforeseen event. For more information, check out irs.gov/publications/p523.

Tim Sullivan is the owner of Clarity Financial LLC, a fee-only advisory firm in Columbia, a CFP practitioner and member of the National Association of Personal Financial Advisors and has earned the Enrolled Agent designation from the IRS.

This article originally appeared on Columbia Daily Tribune: Do you owe any taxes after the sale of your home?