How long have you owned your home?
You must have lived in your home for two out of the last five years in order to qualify for the exclusion. This means that if you keep your house for a while after you move out, you risk losing the exclusion. If your home has appreciated significantly this can be a very costly decision to delay the sale.
How much is the exclusion for?
The exclusion amounts are $250,000 for individuals or $500,000 for married filing joint. This reduces overall gain. One caveat though is that if you have depreciated any part of your property for rental or business usage you must recapture that depreciation in addition to the exclusion.
What if I have lived here longer than my spouse?
The qualifying period is based on each individual's time spent in the property. So, if you have lived in the property for three years, but you were married and had your spouse move in six months prior, only you qualify for the exemption. However, if your spouse was living in the property previous to marriage the timeline is when they lived there, not when you were married. Also, depending on the reason of the move, they may qualify for a reduced exclusion based on the time they lived there for.
Who Qualifies for the Reduced Exclusion?
For most taxpayers who are in a 25% tax bracket, capital gains are taxed at 15%, and this is the rate that applies for the sale of a rental property. For a resale property though this will be taxed as ordinary income at 25%, plus subject to 15% self-employment (social security and medicare) tax, making up a whopping 40% tax rate! There is a big difference between 15% and 40% tax rates.
But what if I refinanced the property and the sale barely pays off the mortgage?
If you refinanced a property and pulled cash out there is no tax due at the time of refinancing, but when you sell the property the total amount of gain on the property will be taxed. For example, let's say you bought that same house in the earlier example, but refinanced it for $150,000 a couple years ago and pulled out the $30,000 you had invested plus another $20,000. When you sell the property you will still owe taxes on the full $50,000 even though the cash proceeds received are only $20,000.
The depreciation recapture trap...
None of these examples take into account depreciation recapture which can be a hefty tax burden even when your sale is classified as a rental. If you have owned a rental property for a number of years you will be hit with recapture of depreciation, and this applies to depreciation allowed or allowable! Rental houses are depreciated over 27.5 years using a straight line method. So, using the example above, if you rented that $130,000 house for three years you would have depreciated it $14,182. This amount will be recaptured at ordinary income tax rates, which at a 25% rate comes to $3,545 in tax.
Are there any other options?
Luckily, real estate has a couple extra options that with a little bit of planning can minimize the impact of taxes on growth of your investment. 1031 Exchanges can be a good way to defer gains by reinvesting the funds from the sale directly into a new purchase of real estate. If the gain is high in the year of sale and that may cause tax troubles, it also is possible to sell using an installment sale that can create a good source of income over coming years while also minimizing tax impact in any particular year.