What you need to know about IRS rules: Tax deadlines and due dates.
The IRS has time limits, but waiting can narrow your relief options while increasing penalties and interest. Here’s what you need to know on tax day.
- Real estate experts want big changes, perhaps doubling the tax-free threshold or eliminating capital gains tax on principal residences.
- Do your homework to reduce your taxes. Capital gains may be reduced by some costs, such as eligibility for major improvements and closing costs.
Potential home buyers who are struggling to find an affordable home may never imagine that some of them are lucky enough to actually consider selling their home because they have so much money to spend.
Seriously?
There’s been a lot of talk in the real estate industry about outdated tax thresholds related to the taxable gains some people may face when selling their long-time home. Some people call this the “hidden housing property tax.”
It wasn’t supposed to be like this.
When did the first capital gain occur on the home sale?
Nearly 30 years ago, then-President Bill Clinton called for couples to be able to keep up to $500,000 in profits from the sale of their homestead tax-free. Both Democrats and Republicans liked the idea, and it was included in sweeping reforms when Congress passed the Taxpayer Relief Act of 1997.
At the time, the initial limit was so high that it was considered to effectively eliminate capital gains tax on the sale of the home.
However, that threshold limit was not indexed to increase based on inflation or home price increases. As a result, depending on where you live, more people than you might think are not eligible for the home sale deduction. And that number is expected to grow even more if home values continue to rise.
Currently, individuals selling a home are allowed to retain up to $250,000 in capital gains from the sale of a home that they have owned and used as their primary residence for at least two of the past five years prior to the date of sale.
For married couples filing jointly, up to $500,000 in capital gains from the sale of similar homes will not be taxed.
“These numbers really haven’t kept up with the times,” said Joel Berner, senior economist at Realtor.com.
Berner said the risk of paying capital gains tax when selling a home is not well known to many people because the 1997 exclusion was large enough for several decades that capital gains tax did not apply to the sale of many primary residences. For years no one talked about this issue.
Your chances of incurring capital gains taxes vary widely depending on home value appreciation in your area, how long you’ve lived in your home, the state you live in, and whether you’re married or single.
Capital gains hotspots likely to expand
A new study by the National Association of Realtors estimates that approximately 13.1 million homeowners nationwide (15% of all homeowner households) already have unrealized capital gains in their homes that exceed the capital gains tax deduction limit.
It is estimated that 5.5% of homes in Michigan are currently over the limit. In Minnesota, it’s 7.7%. In New Jersey, the rate is currently 22.6%. According to the survey, the rate in California is 43.6%.
More homeowners could face this tax burden if home values rise as expected, and the study provides fairly high estimates of how many people could ultimately be at risk if home prices rise steadily in the future.
According to the study, a 30% increase in national home prices would effectively double the number of affected homeowners to more than 27 million households, representing 31.3% of households nationwide over the next few years.
The study notes that since 1997, U.S. home prices have increased about 3.5 times on a national level, and in many metropolitan areas they are rising even faster. Many communities saw severe price increases in 2021 and 2022 following a significant surge in demand with the onset of the COVID-19 pandemic.
Risk remains fairly low in many markets in the Midwest.
What tax changes do some people want?
Still, many real estate experts would like to see major changes to the limits, perhaps doubling the threshold to $500,000 for singles and $1 million for married couples, or eliminating capital gains taxes on primary home sales altogether. They say this is a way to free up some housing supply, encourage home sales in some markets, and potentially prevent further problems in the future.
“It just opens up the housing market,” Varner told the Detroit Free Press, part of the USA TODAY Network. “This allows for more deals and gives people more flexibility to move up.”
The theory is that housing supply is also influenced by the willingness of existing homeowners to sell their homes and move.
Berner said raising the cap would give more people, including seniors, more flexibility to sell their homes without worrying about paying more income tax.
“The people who will be punished the most are those who stay home for long periods of time,” Berner said.
Perhaps they bought during a big drop, like in early 2011 after the financial crisis hit. Maybe it’s an elderly person who has lived in the house for over 30 years.
Some argue that only “a small group of high-income taxpayers” will benefit.
Don’t get me wrong. Most people do not have to pay capital gains taxes on the sale of their home, especially if they are married, live in an area where home prices are not very high, and do not expect to make more than $500,000 on the sale of their home.
And Elena Patel, co-director and senior fellow at the Urban-Brookings Tax Policy Center, said raising the tax exemption level for capital gains on primary residences would do little to meaningfully increase housing supply.
A study by the Urban-Brookings Tax Policy Center found that such tax changes currently proposed by some in Congress “would greatly benefit a small number of high-income and wealthy households.”
Mr Patel said most households already owed no capital gains tax when selling their primary residence under current law.
The report noted that under current law, 95% of all households, and 90% of households age 65 and older, are not liable to pay federal capital gains taxes on the sale of their home because the capital gains generated are below the existing exclusion threshold.
“Expanding the exemption would therefore primarily provide additional tax benefits to a relatively small number of high-income and high-wealth households, but would have a limited impact on overall housing availability,” Patel told the Detroit Free Press.
“It would also increase tax benefits for households that already enjoy significant housing-related tax benefits, such as through mortgage interest deductions.”
Who may be vulnerable?
The study notes that many older homeowners aging out after bereavement or divorce may find themselves facing unexpected capital gains taxes when they sell a home they’ve owned for many years.
“Single filers represent approximately 58% of exposed homeowners,” the report states.
Others who may be vulnerable are homeowners who bought their homes in the early 2000s and before the significant price increases since 2012.
The report says California is distinguished by a large homeownership population and decades of significant price growth. But other large states such as Texas, Florida and New York also have significant numbers of homeowners making more than $250,000 in their housing markets alone, the report said.
It’s hard to determine if there’s anything that would prevent an older homeowner from selling to get their wealth and just pay the taxes. But some people may be wary of paying more in taxes.
Long-time homeowners “have to deal with a lot of things that make it hard for them to afford a bigger house, like rising maintenance costs and insurance costs. But when they sell a bigger house, they get hit with this capital gains tax, so they decide to stay where they are,” Berner said.
How capital gains tax works on the sale of a home
The actual taxes you pay can vary significantly.
Let’s say you’re single and you bought the house in 1996 for $120,000, and now you can sell it for $420,000. In this example, one person may be considering some taxable gain. However, you may pay less tax than you think.
“One of the biggest misconceptions is that homeowners think that once their deductions are exceeded, the entire gain becomes taxable, but that’s not true,” said Tom Oseven, director of tax content and government relations at the National Association of Tax Professionals.
Single filers can typically exclude up to $250,000 in gains, and married couples filing jointly can exclude up to $500,000 if other rules are met.
“Assuming other rules are met, only profits in excess of these thresholds may be subject to tax,” he said.
In this example, you might be looking at $50,000 of taxable profit, but you might not.
Of course, you need to do your homework to reduce your taxes. “Spending on home improvement increases the basis of the home, which can reduce profits,” said Mark Luscombe, principal analyst at Wolters Kluwer Tax & Accounting in Riverwoods, Illinois.
We’re talking about reducing your taxable income by taking into account the big expenses you faced to improve your home, perhaps remodeling the kitchen, building a new house, or adding a new air conditioning system. There are no regular maintenance costs such as painting the bedroom.
“The closing costs of the sale assigned to the seller can also reduce profits,” Luscombe said. “However, depreciation charges charged over the years from business or rental use of the property can reduce the basis and increase profits.”
Taxpayers should take the time to properly calculate their cost basis.
Long-term capital gains on real estate held for more than a year typically qualify for preferential federal tax rates of 0%, 15% or 20%, depending on income, Oseven said.
For many middle-income taxpayers, an additional $50,000 in taxable long-term gains can result in approximately $7,500 in federal taxes at a 15% capital gains rate.
State tax rates vary. Some states have no income tax, while others tax capital gains as ordinary income. Oseven said in a state with a 5% income tax, a $50,000 gain could add about $2,500 in state taxes.
And you want to make sure you’re exempt.
According to the Internal Revenue Service, “Generally, if you have excluded gains from the sale of another home in the two years prior to selling your home, you will not qualify for the exclusion.”
Mr Luscombe said there could be some special circumstances that could be excluded from the exclusion.
“Some people forget that they have to wait two years to apply for exemption again,” Luscombe said.
“For example, this problem can arise when a couple gets married, one spouse sells their home and moves in with the other spouse, then immediately begins looking for a larger home, and within two years sells the other spouse’s home.”
Or, in some cases, he said, people may forget that profits earned from business or rental activities related to depreciation charged on a home after May 6, 1997, are not subject to the capital gains exclusion and may be taxed at the 25% capital gains tax rate.
We’re talking about fairly complex rules. And yes, there are some exceptions. For example, Luscombe said, a partial exemption could apply if the two-out-of-five rule is not fully met in some circumstances. Consider changes in employment, health reasons, or other unforeseen circumstances such as divorce, legal separation, multiple births from the same pregnancy, natural disaster or deprivation of housing.
Of course, even advocates acknowledge that raising the cap on capital gains exclusions will not solve all the problems associated with limited housing supply. More needs to be done.
“The biggest factor is building more homes. Anything that incentivizes builders to deliver inventory is really the ultimate solution,” Varner said.
In general, he said, there should be about 4 million more homes in the U.S., or about 5% more, to accommodate the number of households.
Contact personal finance columnist Susan Tompol: stompor@freepress.com. follow himr X @tompor.
