Thinking About Downsizing Your Home?
Downsizing your home—whether by moving into a smaller home or to a more affordable neighborhood—can help lower your monthly expenses and maintenance costs, and maybe even generate extra cash from a sale.
But it's important to factor the potential taxes into any decision. Selling your home may not be worth it if it triggers a big tax bill.
The basics
Under current law, if you sell your principal residence for a profit, you may be able to exclude up to $250,000 ($500,000 for married couples filing jointly) of capital gains from your income tax.1 This may not be an issue for most people, but if your home has appreciated considerably, you could face a significant bill.
To claim the maximum exclusion, you'll need to pass what the IRS calls the ownership and use tests. This means:
- You must have owned the house for at least two years.
- And you must have lived in the house as your principal residence for two out of the last five years, ending on the date of sale.
There are exceptions to these rules—for example, moving before owning the home for two years due to a job change or experiencing what the IRS designates an "unforeseen circumstance," such as a divorce or natural disaster. In such cases, the IRS will allow you to prorate the exclusion. One thing to note: If you divorce after having lived in the home for just one year, you would be entitled to only 50% of the exclusion.
Additionally, the two years of residency don't have to be consecutive, as long as you've lived in your home for a total of 24 months out of the five years prior to the sale.
You can claim this exclusion on multiple sales but be aware that you can only claim this exclusion once every two years.
Calculate your cost basis
To determine any capital gains, you must subtract your "cost basis" from the selling price.
Your cost basis is not just the purchase price. It can include certain settlement fees, closing costs, and commissions associated with both the purchase and the sale—excluding escrow amounts related to taxes and insurance, etc.2 Add to this the cost of significant capital improvements (but not repairs) you made over time for renovations, additions, roofing, landscaping, and other upgrades. All these improvements will increase your cost basis and, therefore, lower your potential tax liability. Hopefully, you've kept good records because this can add up.
On the other side of the equation, there are a few things that can reduce your cost basis, which would increase not just your profit but potentially your taxes as well. For example, if you received tax credits for energy-related improvements, you'll have to subtract those amounts from your cost basis. Also, if you ever claimed depreciation for a home office, you may have to "recapture" and pay tax on that amount.
Capital improvement or repair?
Tax rules let you add the cost of a capital improvement to your cost basis but not the cost of a repair. The difference? A capital improvement increases the value of your property. A repair simply restores your property to its original condition.
A new deck is a capital improvement. Fixing your plumbing is a repair. Sometimes, though, the distinction is less clear. For example, if you replace your entire roof, that's a capital improvement. But if you simply replace a few shingles, that's a repair.
A sample tax bill
Jon and Jane bought their home in 1988 for $250,000. Now in their mid-60s, they've decided to downsize. They sell their home for $875,000.
Over the years, Jon and Jane did a lot of remodeling and made many home improvements. Because Jane has a home office, they've claimed depreciation on their income tax return, which now has to be subtracted from the cost basis. They are in the 15% long-term capital gains tax bracket.
When Jon and Jane bought their home, they paid $12,500 in allowable settlement fees and closing costs at the time of purchase, and over the years, they spent $50,000 remodeling their kitchen and master bath, $20,000 on a new roof, and $15,000 on new landscaping—for a total cost basis of $347,500 ($250,000+$12,500+$50,000+$20,000). Because they had to recapture $50,000 of depreciation costs for Jane's office, the total cost basis of their home is $297,500.
What did they sell it for?
Jon and Jane sell their house for $875,000, but the $55,000 in commission and sales fees reduces their gross profit to $820,000.
How much did they make?
After subtracting their cost basis of $297,500 from their gross profit of $820,000, Jon and Jane will earn $522,500 in capital gains.
How much do they owe in capital gain taxes?
Because Jon and Jane are filing jointly, they can exclude up to $500,000 of their capital gains, leaving them with a taxable capital gain of $22,500. Based on their income, their long-term capital gains tax rate is 15%, resulting in a capital gains tax bill of $3,375.
Note: Jon and Jane must also "recapture" the $50,000 of home office depreciation deductions on their tax return as an "unrecaptured section 1250 gain." In this example, it will be taxed at the maximum rate of 25% ($12,500 in tax). But they would have to do this even if their capital gain was less than their $500,000 exclusion.
What about renting?
On the plus side, renting releases you from worry about things like property taxes and upkeep—potentially giving you more freedom both economically and emotionally. If you don't commit a chunk of money to another house, you could use the proceeds from a home sale to help fund your retirement. On the minus side, if you rent, you won't be building equity, and you'll be subject to the whims of a landlord.
There's no right or wrong answer. A lot will depend on where you live and how long you plan to stay in your next home. In either case, if you make a considerable profit on the sale of your home, talk to your financial advisor about the best way to invest this money in light of your overall financial situation.
1IRS Publication 523.
2Ibid.