A primary residence is not an investment property and thus has different tax outcomes. Primary residence homeowners can take advantage of certain tax benefits when selling their home. This benefit is called section 121 primary residence tax exclusion.
What is a Primary Residence?
Your primary residence is where you live. It is where you spend most of your time. A few qualifying factors for primary residence status include:
- The home’s address is on your driver’s license, voter registration card, and car registration.
- It’s where you receive your tax returns.
- The home’s address is listed with USPS.
- Closest to where you bank, work, or club/organization you’re affiliated with.
- Family members live close by.
From the IRS’s perspective, spending most of your time at this location is the most important factor. The above points are helpful if you own more than one home (i.e., vacation home). If you own only one home, determining your primary residence is much simpler.
Primary Residence Capital Gains Tax
When selling a home for a gain, you may owe taxes. If you’ve lived in the home for more than a year, you’ll pay long-term capital gains taxes. To figure out your gain, you must first determine your cost basis in the home.
A basis is used to determine the amount of taxes owed. The sales price minus the basis (plus sales cost) equals the gain or loss. A larger basis will result in a smaller gain and thus less in taxes. If you sell your home below the basis, you’ll have a loss. A loss on a primary residence is not deductible.
Even if you don’t owe any taxes, it’s best to report it on your tax return. If you got a 1099S (i.e., proceeds from real estate transaction), you have to report it anyway.
The basis can change as you own the home due to home improvements, realtor costs, and other expenses. This change in basis is called the adjusted basis. The adjusted basis is then used to figure out the gain when the home is sold.
Note that it’s important to keep any receipts related to capital improvements on the home. The IRS may want to verify them.
Depending on the expense, the basis will adjust up or down. Here’s a quick guide showing how different expenses affect the basis.
- Acquisition costs (i.e., title-related, transfer fees, surveys).
- Cost for additions or improvements.
- Cost of installing utility service.
- Property-related legal fees.
- Restoration cost related to damage or lost due to theft, flood, fire, or other casualty.
- Home energy improvement tax credits received after 2005.
- Depreciation (i.e., home used as rental or business).
- Insurance payouts related to casualty or theft loss.
- Deductible for casualty loss that wasn’t covered by insurance.
- Gain on sales of a home before May 7, 1997.
- Money received for granting an easement.
The following expenses do not affect the cost basis:
- Appraisal fees
- Pest inspection fees
- Credit report fees
- Mortgage broker's commissions
- Loan fees (not points)
To see how the basis is determined, let’s go through an example.
Home purchase price: $250,000
+ Closing cost: $7,000
+ Improvements while occupying home: $50,000
= Adjusted basis: $307,000
Home sales price: $400,000
- Closing cost: $30,000
= Sale Proceeds: $370,000
Now we can calculate the capital gain:
The capital gain on this home is $63,000. However, this may not be the amount that is owed in taxes.
Is There a Way to Avoid It?
The IRS tax code has something called section 121, which allows primary residence homeowners to exclude a certain amount of gains on the sale of their home. As usual, with tax benefit perks, there are strings attached.
The section 121 exclusion allows the following amounts to be excluded, depending on your tax filing status:
- Single — $250,000
- Married — $500,000
The condition is that you must have lived in the home for 2 of the last 5 years. The 2 years do not need to be 24 consecutive months. This also means that you can complete the transaction every two years. The exclusion applies to federal taxes only. State taxes still apply but may be reduced if the state has a credit or other favorable tax reductions on the sale of a primary residence.
From the above example, the $63,000 is an allowed exclusion. Taking another scenario, the allowed exclusion on a $300,000 gain for a single filer is $250,000. Taxes will be owed on $50,000 of the gain.
The more an investor is able to increase their adjusted cost basis, the more they will decrease their gain and, thus, potential tax bill. Of course, if the home appreciates at a rate that keeps ahead of any upwardly adjusting cost basis, the potential gain will not decrease. The primary residence tax exclusion is fairly straightforward, but it's always best to work with your financial or tax advisor when selling a home.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
This is a hypothetical example that is demonstrating some mathematical principles. It does not illustrate any investment products and does not show past or future performance of any specific investment. Investing involves risk, including the loss of principal.