Selling your house might be a much less taxing experience than you expect. The Internal Revenue Service gives you a generous capital gains exclusion that lets you potentially enjoy hundreds of thousands of dollars in tax-free gains. However, if you have a home office or if you are selling a home other than your personal residence, you could end up with a tax liability.
If you lived in the home that you sold for at least two of the past five years and used it as your primary residence, you get a generous tax exemption. The IRS will let you exclude $500,000 in gain on the sale of your house from taxes if you are married and file a joint return, while all other filers get to exclude $250,000. If your profit is less than this threshold, you won't have to pay any taxes.
Other Personal Homes
The home sale capital gains exclusion doesn't apply to personal residences that aren't your primary home, so you will have to pay tax on any capital gains on the sale. If you held the house for less than one year, you will pay capital gains tax at your regular income tax rate, but if you held it for over one year, you qualify for the preferential long-term capital gains rate. Most taxpayers pay a 15 percent federal rate for capital gains. If your adjusted gross income is over $450,000 per year if you are married and file jointly or $400,000 if you are single, the rate goes up to 20 percent. Also, if your income is over $250,000 or $200,000, depending on if you are married or single, long-term and short-term capital gains will also be subject to an additional 3.8 percent Medicare surcharge.
Claiming the home office deduction opens you up to depreciation recapture tax liability when you sell your house. The IRS lets you depreciate the portion of your home that is used as a home office and, if you sell your house for more than its value after subtracting out all of the depreciation you claimed, you'll have to pay tax on the depreciation. Depreciation recapture tax is 25 percent of the depreciation and you have to pay it on the depreciation that you could have claimed, even if you didn't claim it.
When you sell an investment property, you have to pay the capital gains tax on the profits just like with a personal home that isn't a primary residence. If you sell it for more than its depreciated price, the IRS also requires you to pay depreciation recapture tax on any depreciation that you claimed on the entire property. However, if you follow all of the IRS rules and use the proceeds of your sale to buy more investment property, you may be eligible to defer all of your taxes by conducting the transaction as a tax-deferred exchange, also known as a 1031 exchange.
Mortgage Payoffs and Taxes
Paying off your mortgage generally has on impact on your taxes when you sell your house. From the IRS's perspective, using your money to pay off a loan is a non-event. If you have $100,000 in the bank and a $75,000 loan, you have a $25,000 net worth. However, if you pay off the loan, you'll have $25,000 in the bank, no debt, and the same $25,000 net worth. The exception to this rule occurs if you do a short sale. If your bank reduces the principal you owe them, the IRS can treat this as taxable income. Between 2007 and 2013, the IRS waived taxes on debt retirement for primary personal residences, but all other loan reductions are taxable and, in 2014, the exclusion for primary residences was set to expire.
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