The tax applies only to people with relatively high incomes. If you’re single, you must pay the tax only if your adjusted gross income (AGI) is over $200,000. Married taxpayers filing jointly must have an AGI over $250,000 to be subject to the tax. Your adjusted gross income is the number on the bottom of your IRS Form 1040. It consists of your income from almost all sources, including wages, interest income, dividend income, income from certain retirement accounts, capital gains, alimony received, rental income, royalty income, and unemployment compensation, reduced by certain “above the line” deductions such as IRA contributions and one-half of self-employment taxes.
The tax applies only to investment income. This includes:
This includes just about any income not derived from an active business or from employee compensation.
The Medicare tax is a 3.8% tax, but it is imposed only on a portion of a taxpayer’s income. The tax is paid on the lesser of (1) the taxpayer’s net investment income, or (2) the amount the taxpayer’s AGI exceeds the applicable AGI threshold ($200,000 or $250,000).
Example: Phil and Penny are a married couple who file a joint return. Together they earn $200,000 in wages. They also earn $200,000 in net rental income and $150,000 in other investment income. Their AGI is $550,000, including $350,000 in net investment income. They must pay the 3.8% Medicare tax on the lesser of (1) their $350,000 of net investment income, or (2) the amount their AGI exceeds the $250,000 threshold for married taxpayers—$300,000. Since $300,000 is less than $350,000, they’ll have to pay the 3.8% tax on $300,000. Their Medicare contribution tax for the year will be $11,400 (3.8%
]]>To qualify for the $250,000/$500,000 home sale exclusion, you must own and occupy the home as your principal residence for at least two years before you sell it.
What if you have to sell your home even though you don't comply with all the requirements for the exclusion? This would occur, for example, if you sell before you have lived in the home for two years, or if you have already used the exclusion for another home less than two years prior to this sale. If this happens, you may still qualify for a partial exclusion if you have a good excuse for selling the property. Good excuses include:
A change in the place of employment for you, your spouse, any co-owner of the property, or any other person who uses your home as his or her principal residence is always a valid excuse if the location of the new job is at least 50 miles further away from your old home. This is the same distance rule that applies for the moving expense deduction. Moves of less than 50 miles could also qualify depending on the circumstances.
Health problems are a valid excuse if a doctor recommends that you move for health reasons—for example, you have asthma and your doctor tells you that living in Arizona would be better for you than Maine. The health problems can belong to you, your spouse, any co-owner of the property, any other person who uses your home as his or her principal residence, or a close family member of any person in the prior categories—for example, a child or parent. Thus, for example, you can move if you need to be closer to an ill parent. If you want to use the health exception, be sure to get a letter from your doctor stating that the move is for health reasons and what they are. Keep the letter with your tax files.
If you have a valid excuse for not complying with all the requirements for the exclusion, you'll get a partial exclusion—not the whole $250,000/$500,000. The amount is ordinarily limited to the percentage of the two years that you fulfilled the requirements. For example, if you own and occupy a home for one year (50% of two years) and have not excluded gain on another home in that time, you may exclude 50% of the regular maximum amount—up to $125,000 of gain for a single taxpayer and $250,000 for married couples. The percentage may be figured by using days or months.
]]>The only way you can obtain a deduction if you sell your home at a loss is to convert it to a rental property before you sell it. However, your deductible loss will be limited. This is because when you convert property you held for personal use to rental use your tax basis (value for tax purposes) is the lesser of the following values on the date of the conversion:
Your tax basis is basically the property's original cost, plus the cost of any improvements you've made (but not repairs), minus any depreciation deductions taken--for example, if you claimed the home office deduction. Fair market value is the price at which the property would change hands between a buyer and a seller, neither under undue pressure to buy or sell, and both having reasonable knowledge of all the relevant facts. Sales of similar property in the area are helpful in figuring out the fair market value of the property. You may also elect to have the property’s value appraised as of the date of its conversion to rental property. Either way, it's very important to have a good estimate of your home's fair market value on the date of the conversion.
Because of this rule, if your personal residence has lost value since you bought it, turning it into a rental home won’t allow you to deduct the loss that occurred before the conversion when you eventually sell it. Only the drop in value after the conversion is deductible.
To learn more, see Nolo's section on Tax Deductions and Credits for Homeowners.
]]>One confusing thing about basis is that it can change over time. When this occurs, your basis is called "adjusted basis." To determine the amount of your basis, you begin with your starting basis and then add or subtract any required adjustments.
If you’ve purchased your home, your starting point for determining the property’s basis is what you paid for it. Logically enough, this is called its cost basis. Your cost basis is the purchase price, plus certain other expenses. You use the full purchase price as your starting point, regardless of how you pay for the property—with cash or a loan. If you buy property and take over an existing mortgage, you use the amount you pay for the property, plus the amount that still must be paid on the mortgage.
Example: Jan buys her home for $60,000 cash and assumes a mortgage of $240,000 on it. The starting point for determining her basis is $300,000.
Certain fees and other expenses you pay when buying a home are added to your basis in the property. Most of these costs should be listed on the closing statement you receive after escrow on your property closes. However, some might not be listed there, so be sure to check your records to see if you’ve made any other payments that should be added to your property’s basis. These include real estate taxes owed by the seller that you pay, settlement fees and other costs such as title insurance.
You cannot use cost as the starting basis for a home that you received as an inheritance or gift. The basis of property you inherit is usually the property’s fair market value at the time the owner died. Thus, if you hold on to your rental property until death, your heirs will be able to resell it and pay little or no tax—the ultimate tax loophole.
Example: Victoria inherits her deceased parents' home. The property’s fair market value (excluding the land) is $300,000 at the time of her uncle’s death. This is Victoria’s basis. She sells the property for $310,000. Her total taxable profit on the sale is only $10,000 (her profit is the sales price minus the home's tax basis).
The basis of a home or other property you receive as a gift is its adjusted basis in the hands of the gift giver when the gift was made.
If you build your home yourself, your starting basis is the cost of construction. The cost includes the cost of materials, equipment, and labor. However, you may not add the cost of your own labor to the property’s basis. Add the interest you pay on construction loans during the construction period, but deduct interest you pay before and after construction as an operating expense.
Your basis in property is not fixed. It changes over time to reflect the true amount of your investment. This new basis is called the adjusted basis because it reflects adjustments from your starting basis.
Your starting basis in your home must be reduced by any items that represent a return of your cost. These include:
You must increase the basis of any property by:
In addition, assessments for items that tend to increase the value of your property, such as streets and sidewalks, must be added to its basis. For example, if your city installs curbing on the street in front of your rental house, and assesses you for the cost, you must add the assessment to the basis of your property.
The most common way homeowners increase their basis is to make home improvements. Improvements include any work done that adds to the value of your home, increases its useful life, or adapts it to new uses. These include room additions, new bathrooms, decks, fencing, landscaping, wiring upgrades, walkways, driveway, kitchen upgrades, plumbing upgrades, new roofs.
However, adjusted basis does not include the cost of improvements that were later removed from the home. For example, if you installed a new chain-link fence 15 years ago and then replaced it with a redwood fence, the cost of the old fence is no longer part of your home's adjusted basis.
Example: Jane purchased her home for $200,000 and sold it ten years later for $300,000. While she owned the home, she made $50,000 worth of improvements, including a new bathroom and kitchen. These increased her basis to $250,000. She also received $10,000 in insurance payments one year to reimburse her for storm damage to the house. This payment decreased her basis to $240,000. She subtracts her $240,000 adjusted basis from the $300,000 sales price to determine her gain from the sale—$60,000.
Also see Tax Reasons to Keep Good Records of Home Improvements.
]]>However, to qualify for the tax exclusion, you must own and occupy the home as your principal residence for at least two years out of the five years before you sell it. Moreover, you can use the exclusion only once every two years. For details, see “The $250,000/$500,000 Home Sale Tax Exclusion.”
Unfortunately, it’s not always possible to satisfy the requirements for the full $250,000/$500,000 exclusion—for example, if you buy a home and have to move one year later, you won’t qualify for the full exclusion. In this event, however, you may be able to salvage a partial exclusion.
The IRS is fairly lenient here and says you can get a partial exclusion if you have a good excuse for not living in the home for two full years before you sell. It has established some standard good excuses. These include a change in your place of employment, or health problems that require you to move. For details on these commonly used excuses, see “Exceptions to the Home Sale Exclusion Two Year Rule.”
But what if you have to move for reasons other than a change in your job or health problems? Fortunately, good excuses are not necessarily limited to these two. There is a third catch-all good excuse category: These are circumstances you didn't foresee when you bought the home that forced you to sell it within two years.
The IRS has established several unforeseen circumstances safe harbors. If you move for one of these reasons, you will automatically qualify for a partial tax exclusion:
However, all is not necessarily lost if the reason for your move does not fall within one of the safe harbors. Taxpayers have been able to convince the IRS that their moves were caused by many different types of unforeseen circumstances and they were therefore entitled to a partial tax exclusion. These include:
Extreme Bullying. A single mother of two daughters was forced to move after less than two years because one of her children was subjected to extreme bullying at school. (Letter Ruling 20082016.)
Unexpected Pregnancy and Breakup. An engaged couple bought a house together, but broke up after seven months after the woman unexpectently became pregnant. They had to move because the house wasn’t big enough for two adults to live in separately with a child, and neither could afford it alone. (Letter Ruling 200652041.)
Adoption. A married couple wanted to adopt a foreign child. However, state law required that they provide a separate bedroom for the girl, so they sold their home to rent a larger home with an additional room for the adopted child. (Letter Ruling 200613009.)
Personal Safety. A couple unknowingly purchased a home in a high crime area. They sold it after one of them was severely assaulted by several neighbors, requiring a trip to the emergency room, and their son was assaulted and threatened. (Letter Ruling 200601009.)
Fear of Criminal Retaliation. A police officer and his family sold their home after he was threatened with death by the associates of a drug dealer he arrested. (Letter Ruling 200615011.)
Move From Seniors-Only Community. An older couple purchased a home in a senior-only retirement community. Soon thereafter, their adult daughter wanted to move in with them because she lost her job and was getting divorced. However, the daughter and her child could not live in the retirement community because of their age. Thus, the couple sold their home and purchased a new home in which their daughter and grandchild could live with them. (Letter Ruling 20601023.)
However, there are certain types of life events that the IRS does not regard as unforeseen circumstances. If you sell your home because of one of these, you won’t qualify for a partial home sale exclusion. These include:
A partial home sale tax exclusion is ordinarily limited to the percentage of the two years up to the date of the sale that you owned and occupied the home as your principal residence.
Example: Heather purchases a one-bedroom condo in Chicago. Six months later she loses her job and collects unemployment. She is unable to pay her mortgage, sells the condo, and moves in with her parents. She owned and occupied the condo for one year (50% of two years) and did not exclude gain on another home during that time. Thus, she may exclude 50% of the regular maximum amount. Since she is a single taxpayer, she may exclude up to $125,000 of her gain—50% of the regular $250,000 exclusion for singles.
]]>If you’re a homeowner this is the one tax law you need to thoroughly understand.
Here’s the most important thing you need to know: To qualify for the $250,000/$500,000 home sale exclusion, you must own and occupy the home as your principal residence for at least two years before you sell it. Your home can be a house, apartment, condominium, stock-cooperative, or mobile home fixed to land.
If you meet all the requirements for the exclusion, you can take the $250,000/$500,000 exclusion any number of times. But you may not use it more than once every two years.
The two-year rule is really quite generous, since most people live in their home at least that long before they sell it. (On average, Americans move once every seven years.) By wisely using the exclusion, you can buy and sell many homes over the years and avoid any income taxes on your profits.
One aspect of the exclusion that can be confusing is that ownership and use of the home don’t need to occur at the same time. As long as you have at least two years of ownership and two years of use during the five years before you sell the home, the ownership and use can occur at different times. The rule is most important for renters who purchase their rental apartments or rental homes. The time that a purchaser lives in the home as a renter counts as use of the home for purposes of the exclusion, even though the renter didn't own the home at the time.
To qualify for the home sale exclusion, you don’t have to be living in the house at the time you sell it. Your two years of ownership and use may occur anytime during the five years before the date of the sale. This means, for example, that you can move out of the house for up to three years and still qualify for the exclusion.
This rule has a very practical application: It means you may rent out your home for up to three years prior to the sale and still qualify for the exclusion. Be sure to keep track of this time period and sell the house before it runs out.
To qualify for the exclusion, you must have used the home you sell as your principal residence for at least two of the five years prior to the sale. Your principal residence is the place where you (and your spouse if you're filing jointly and claiming the $500,000 exclusion for couples) live.
You don't have to spend every minute in your home for it to be your principal residence. Short absences are permitted—for example, you can take a two month vacation away from home and count that time as use. However, long absences are not permitted. For example, a professor who is away from home for a whole year while on sabbatical cannot count that year as use for purposes of the exclusion.
You can only have one principal residence at a time. If you live in more than one place—for example, you have two homes—the property you use the majority of the time during the year will ordinarily be your principal residence for that year.
If you have a second home or vacation home that has substantially appreciated in value since you bought it, you’ll be able to use the exclusion when you sell it if you use that home as your principal home for at least two years before the sale.
There are certain additional requirements you must meet to qualify for the $500,000 exclusion. Namely, you must be able to show that all of the following are true:
If either spouse does not satisfy all these requirements, the exclusion is figured separately for each spouse as if they were not married. This means they can each qualify for up to a $250,000 exclusion. For this purpose, each spouse is treated as owning the property during the period that either spouse owned the property. For joint owners who are not married, up to $250,000 of gain is tax free for each qualifying owner.
If your spouse dies and you subsequently sell your home, you qualify for the $500,000 exclusion if the sale occurs within two years after the date of death and the other requirements discussed above were met immediately before the date of death.