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Sale of a Principal Residence as Income

Instructor: Ian Lord

Ian has an MBA and is a real estate investor, former health professions educator, and Air Force veteran.

In this lesson, we will look at the rules for when and the profits of selling a personal residence are taxed, as well as the different tax rates that apply depending on the circumstances of the sale.

Taxes on Sale of Home

Brad is in luck! He just sold his house as part of an impending move and stands to make about $35,000 when the deal is done. He is concerned that he will have to set aside a certain amount of that to pay for any taxes, but what exactly does he owe? Let's walk him through how taxes work on the sale of a personal residence.

Capital Gains

Normally when a capital asset such as a piece of real estate is sold, the difference between the basis and the sale price minus expenses is taxed at capital gains tax rates. If Brad happened to own the residence for less than one year he would owe short-term capital gains taxes which is the same rate as his income tax bracket. So if he's in the 25% tax bracket he would owe 25% of the $35,000 profit resulting in a tax bill of $8,750.

If Brad owned the house for more than one year, he would owe long-term capital gains taxes on the sale. As of 2017, long-term capital gains range from 0% for taxpayers in the lowest tax bracket up to 28% for those in the highest tax brackets. The important thing to know is that long-term capital gains tax rates are significantly lower than short-term capital gains tax rates, so it might be worth waiting until after one year of ownership to complete any property sales.

Tax Exemption

Luckily for Brad, in his situation he does not owe any tax at all on the sale of his home! How is this? Brad used the house as his principal residence; he actually lived in the home instead of owning it as a rental or vacation property. Under Section 121 of the IRS code, $250,000 in capital gains can be exempted for a single taxpayer from the sale of his or her primary residence. This exemption is doubled to $500,000 for a married couple filing jointly.

In addition to meeting the principal resident test, Brad must have lived in the home for a total of two years out of the last five to qualify for the tax exemption. This means he could move out and lease the property to a tenant, but then sell the house up to three years later and still use the exemption. If Brad did not pass the principal residence or the five year test, than the proceeds would be taxed at his capital gains rates. Of course, he found himself in the lowest tax brackets and qualifies for long-term capital gains than he still might not have any tax burden.

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