The process of selling your home can be overwhelming. Especially in today’s market where it’s common for a home to sell within the first week of being listed. While signing a sales contract can certainly be a relief, feelings of euphoria quickly fade when the seller realizes they must move out and find a new place to live… likely in short order and possibly in an entirely new and unfamiliar area. Several times in the past year I’ve worked with clients who are desirous of selling their home and moving to another – either to shorten commute, increase space for a growing family, or simply change locations. Of these clients, many have paid rent in the past and think being a landlord could prove profitable; or they have realized tremendous growth in the value of their property and believed the trend will continue for years to come. So why sell now? After all, some of the most desirable areas in central Ohio, and around the country, have appreciated in value by almost 50% since real estate started its recovery in 2012.*
As an investment and tax advisor, I appreciate the benefits of real estate investing, but before you decide to become the next great real estate mogul, you should consider a great tax loophole that is only available for the first few years following your decision to move out of your primary residence. Under this particular section of the tax code, you could potentially avoid taxes on all appreciation you experienced while owning the property.
This leads me to the erroneous assumption where many people think their primary residence is not subject to capital gains tax when they sell. While this is certainly true in most cases, the tax code actually stipulates that a home seller is only eligible to exclude from capital gains taxes the first $250,000 of profit. This exclusion doubles to $500,000 for those who are married and filing jointly. To qualify for the full exclusion amount, the seller(s) must have owned and occupied the home as their primary residence for at least two of the past five years. It’s important to note the IRS requires both spouses to satisfy the two-year requirement in order to be eligible for the full $500,000 exclusion; however, the two-year requirement does not need to be satisfied during the same period for each spouse. As unique as it might sound, I’ve actually come across a scenario recently where a married couple did not qualify for the full $500,000 exclusion. In this particular case, the home was owned and occupied exclusively by one spouse prior to their marriage, and subsequent cohabitation.
The “Two-year rule” is only one of several considerations that should be factored into any decision to hold onto a property as an investment:
- Does the property make sense as a rental? Often the rate of return on a rental property is at or below what has historically been achieved by the stock market.
- Do you want to be a landlord? Will you actively manage the property or hire a separate manager to do so on your behalf?
- If you’re going to manage the rental yourself, does the decision anchor you to a specific location?
- If you hold the property past the three-year mark and don’t qualify for the exclusion, mandatory recapture of depreciation will cause a tax liability in the future, even if the property does not appreciate in value.
- This could be deferred further through the use of a section 1031 property exchange.
- If you qualify for and utilize the exclusion, you are ineligible to use the exclusion again for another two full calendar years.
As you can see, there are many factors to consider before making the transition from homeowner to landlord.
To summarize, not all property sales are excluded from capital gains taxation. It just happens that most property sales are below the applicable per person exclusion amount, so capital gains are not an issue. Given the notable increases in property values around the country, and specifically in desirable neighborhoods in central Ohio, more properties could be subject to this tax. The exclusions allow sellers to avoid tax, but the sellers must beware of some critical requirements. For those who choose to hold onto their property as a rental, rather than sell, the biggest requirement is that you must have lived in the property for two of the last five years. This often means you must sell the property within 3 years of moving out, to qualify for the full exclusion.