If any of your clients sold a home this year, they’ll likely have questions for you when it’s time to file their return. The following facts will help you prepare their return, avoid unnecessary taxes, and walk them through the tax implications of the sale:
1. Capital gains can (usually) be excluded
If your client has a capital gain on the sale of their home, they may be able to exclude all or part their gain from their tax return. The IRS has a six-step eligibility test to determine if they qualify for the exclusion:
Step 1: Automatic Disqualification
If either of the following are true of your client, they are automatically disqualified from taking the exclusion:
- They acquired the property through a like-kind exchange (1031 exchange), during the past 5 years.
- They are subject to expatriate tax.
Step 2: Ownership
To qualify for the exclusion, your client must have owned the home for at least two of the last five years before the sale. In the case of married couples, only one spouse needs to meet the ownership requirement.
Step 3: Residence
The home must have been your client’s main residence for at least 24 months of the last five years. The 24 months do not need to be consecutive. For married couples, both spouses must meet this requirement to get the full exclusion.
Step 4: Look Back
The look back requirement only allows taxpayers to take the exclusion once every two years. If your client sold a home and took the exclusion during the two years prior to the current sale, they won’t qualify for the exclusion again this time.
2. There are exceptions to the ownership and residence rules
Step 5: Exceptions
If your client doesn’t meet the ownership and residence rules above, they could still qualify for the exclusion if they meet certain exceptions. Some of the most common exceptions apply to newly divorced or widowed taxpayers and members of the military or other government services.
Divorced and separated taxpayers may treat any time their former spouse owned the home as time that they owned the home, but they must still meet the residence requirement on their own.
Widowed taxpayers who don’t meet ownership or residence requirements on their own can use time that their late spouse owned or lived in the home to qualify.
Military and other government service members may waive the residence requirement if their duties prevented them from actually living in the home for 24 months.
See IRS Publication 523 for more details on these exceptions and other less common exceptions.
3. There’s a limit on excluding gains
If your clients meet the eligibility requirements, they’ll be able to deduct up to $250,000 of capital gains from the sale of their home, or up to $500,000 for couples who are married filing jointly. The Net Investment Income Tax will not apply to the excluded gain.
4. Your clients may qualify for a partial exclusion
Step 6: Final Determination
On Step 6 of the eligibility test, you’ll determine if your client meets all of the above the requirements for the full exclusion. If so, you can use Worksheet 1 to find their exclusion limit.
If not, they may qualify for a partial exclusion if the move happened for work-related reasons, health-related reasons, or unforeseen circumstances. See Publication 523 for details on these special circumstances.
5. Some home sales must be reported
If your client’s gain is not taxable, they may not need to report the sale to the IRS on your tax return.
However, they must report the sale on their tax return if they can’t exclude all or part of the gain or if they choose not to claim the exclusion. That’s also true if they receive a Form 1099-S, Proceeds From Real Estate Transactions. If you must report your client’s sale, be sure to review the Questions and Answers on the Net Investment Income Tax on IRS.gov.
6. Losses on a primary home cannot be deducted
If your client’s home sells for a loss, they may hope they to deduct the loss from their taxes. Unfortunately, they can’t deduct any losses from the sale of their main home. If it was a commercial property, however, they can deduct the loss.
7. Special rules apply to the first-time homebuyer tax credit
Some homebuyer credits and federal mortgage subsidies must be “recaptured” upon the sale of the home. In other words, your client may have to pay back credit or subsidy by paying extra taxes on the sale. If they claimed the first-time homebuyer credit when they bought the home, use Form 5405, Repayment of the First-Time Homebuyer Credit to see how much they must pay back or if they qualify for an exception.
8. The IRS needs their new address
It’s a simple, essential, but commonly overlooked step in selling a home: Reporting the change of address to the IRS. Failing to do so may mean your client misses out on important communications from the IRS, so be sure to help them file Form 8822, Change of Address.
For more ways to educate your clients on home ownership and taxes, read up on these tax benefits of owning a home!
This article was last updated on 07/05/2022.
