If you own a home, it’s probably your most valuable financial asset, so if you decide to sell, you’ll want to walk away with as much money as you can. However, when you make a profit by selling assets like real estate, the government gets a piece of the action through taxes. So, the question becomes: how can you come away with as much of the profit as possible?
The answer is to know the rules around taxes. Currently, there is a capital gains tax exemption for homeowners if you meet the following criteria: 1. You must have owned the home for at least two of the last five years ending on the date of the sale. 2. You must have used it as your primary residence for at least two years during the past five-year period.
If these are true for you, you will not be taxed on the first $250,000 of profit as an individual or the first $500,000 if you are a couple. And there’s proposed federal legislation to update these 25-year-old exemptions to double the exemption amounts and index them to inflation (so, $500,000 for individuals and $1m for couples and then future adjustments based on inflation).
Knowing about this could have a significant impact on your decision-making. If you were thinking about renting out your home for a few years while you explore other options (or until the housing market improves), be aware that after three years of not living in your house, you would be on the hook for capital gains tax on every penny of the profits from the sale of your home.
As with all financial decisions, it’s best to do a cost-benefit analysis. The benefits of turning your home into a rental could mean additional income. The question is whether that income is enough to offset the costs. Becoming a landlord comes with some downsides: allowing strangers to live in your home, dealing with all manner of repairs at all hours of the day and night, assuring bills are paid on time, and complying with the never-ending legal mandates afforded to tenants.
You can mitigate much of this hassle by hiring a property management firm, but then you have to pay for that service, which cuts into your profit. The bottom line is that having renters means you will either have to pay with your time or your money, so you’ll need to determine whether the proceeds are worth the cost.
It’s also good to remember that there’s no guarantee the housing market will become more favorable within your time horizon. Even if you are lucky enough to time the market so you can charge an extra $50,000 for your house, it may not do you any good if you’re outside the capital gains exemption timeline and you end up paying an additional $80,000 in capital gains tax.
One hidden cost people sometimes forget about when trying to figure out how to manage their finances is opportunity cost—the cost of what you could have done with the money that’s currently tied up. If you keep your money invested in your current property, that means it is not available for other uses. Timing the market is nigh impossible, but that doesn’t mean you shouldn’t consider how best to use your wealth to create more wealth.
As always when I write about the tax implications of real estate, my intent is to provide food for thought. If you want advice, you should talk to your tax accountant or financial advisor. I’m using broad brush strokes and your tax advisor can address your particular situation. For example, sometimes there are exemptions for veterans or others.
If you have questions about property management or real estate, please contact me at email@example.com or call (707) 462-4000. If you have an idea for a future column, share it with me and if I use it, I’ll send you a $25 gift certificate to Schat’s Bakery.
Dick Selzer is a real estate broker who has been in the business for more than 45 years.