Preface: Do you own a house whose value has increased since you bought it? If so, you might be curious about the tax consequences if you sell it. The taxes for selling a house vary depending on the scenario. This article explores some of the tax consequences when selling houses.
Tax Planning on Residential Real Estate Transactions (Segment II)
Credit: Jacob M. Dietz, CPA
Business of Buying and Selling
For this scenario, assume the profitability of buying and selling houses impressed John so much that he decided to quit his construction job to buy and sell houses full-time. He started buying houses, fixing them up himself, and then selling them at a profit. John managed to sell a house about every 2 months. In this scenario, John operates a business. The profits therefore would not be capital gains even if he managed to hold onto a property for more than a year. Furthermore, if John does not have an approved Form 4029 exempting him from self-employment tax, then John would owe self-employment tax on the earnings from his house-flipping business.
Since it is a business, John should carefully track expenses associated with it. Levi asked John to track which expenditures add basis to the property and which can be deducted immediately. Levi explained that certain fees paid when purchasing should be added to the basis, such as recording fees and transfer taxes. Construction costs to improve the house, such as adding a bathroom or a new retaining wall, should also be added to the basis. When John sells the property, the basis will then be subtracted from the sales price, reducing John’s income. John and Levi should also consider if there are any filing requirements for his business, such as 1099s.
“One such advantage is the Section 199A Qualified Business Income Deduction. This taxpayer-friendly part of the tax system allows John to deduct up to 20% of net income from his house-flipping business, subject to certain restrictions”.
Although there is a higher tax rate if he is in the business of flipping houses instead of investing in properties for more than a year, there are also some advantages. One such advantage is the Section 199A Qualified Business Income Deduction. This taxpayer-friendly part of the tax system allows John to deduct up to 20% of net income from his house-flipping business, subject to certain restrictions.
Buy and Use as Principal Residence
Let’s change up the first scenario. Suppose John buys the brick rancher for 200,000, and he really likes the house. He likes it so much that he moves in after marrying Rose, and they live there for 3 years. When John and Rose sell the house 3 years and 1 month after purchase, they sell it at a spectacular $100,000 gain. Before selling, John called Levi to ask him what his federal tax bill would be. Levi explained how the federal tax system allows them to exclude that gain. If a taxpayer is married filing joint, he and his spouse can exclude up to $500,000 (it would only be $250,000 if John were single) of the gain on a house that was their principal residence for at least 2 out of the last 5 years.
This exclusion can only be taken once every 2 years. Levi also mentioned that there are various exceptions to the rules which could help taxpayers exclude at least part of the gain even if they do not meet the normal requirements but have special conditions. Special conditions include the death of a spouse, a health-related move, a work-related move, and others. John and Rose met all the requirements, and therefore they gained $100,000 without needing to pay a dime in federal taxes on the gain.
“Levi explained to them that they could exclude the gain from the sale of the lot as part of the transaction of selling their home, if they sold the lot within two years of selling the home, and if the total gain did not exceed $500,000”.
Let’s change up the principal residence scenario. Suppose that when John purchased the home, he also purchased a vacant lot on a separate deed next to it. John and Rose planted grass on the vacant lot, and treated it as part of their home’s yard. Levi explained to them that they could exclude the gain from the sale of the lot as part of the transaction of selling their home, if they sold the lot within two years of selling the home, and if the total gain did not exceed $500,000.
Final Thoughts
As you can read, taxes on house sales really varies. If you want to sell a house, talk with a tax expert before finalizing the sale. The tax expert may be able to help you find a benefit, such as waiting a little longer until a time deadline passes. Furthermore, if you will owe taxes, then the tax expert may be able to estimate roughly your tax liability so you can stow away some money to pay what is owed.