Only on the part of your gain above your exclusion. If the home has been your primary residence for at least two of the last five years, you can generally exclude up to $250,000 of gain from federal tax, or $500,000 for a married couple filing jointly.
Long-time owners in Northern Virginia are the people most likely to go over that limit. The exclusion amounts were set in 1997 and have never been adjusted for inflation.
How to figure your gain
Your gain is different from your equity. Start with your sale price and subtract your costs of sale. Then subtract what you originally paid for the home and the cost of documented improvements you've made since. Paying down your mortgage doesn't change the result.
An illustrative example
A married couple bought their home in the 1990s and is selling it now.
| Sale price | $1,100,000 |
| Costs of sale | −$71,000 |
| Original purchase price | −$250,000 |
| Documented improvements | −$80,000 |
| Gain | $699,000 |
| Exclusion for a married couple | −$500,000 |
| Taxable gain | $199,000 |
All figures are estimates for illustration only and are not tax advice. Your gain and tax depend on your records, your filing status, and your income. Confirm with your tax adviser.
Without the $80,000 in improvement records, their taxable gain would be $279,000.
How the taxable part is taxed
- Federal: as a long-term capital gain. Higher-income sellers may also owe the 3.8% net investment income tax on the taxable part.
- Virginia: as ordinary income on your state return. Virginia has no separate capital gains rate.
- Medicare premiums: a large gain raises your income for the year, which can increase your Medicare Part B and Part D premiums two years later.
If your spouse has died
Two separate rules help a surviving spouse, and you can use both at the same time.
- The $500,000 exclusion, for two years. If you sell your primary home within two years of your spouse's death and haven't remarried, you can generally still exclude up to $500,000 of gain. After two years, your limit drops to $250,000.
- A stepped-up basis on your spouse's share. In Virginia, when a home is owned jointly by spouses, the half that belonged to your spouse is revalued to its market value on the date of death. Your half keeps its original basis. If your spouse owned the home alone, the whole home is revalued. This step-up doesn't expire.
Here's how the two work together. A couple bought their home jointly for $200,000. It was worth $1,200,000 when one spouse died. The survivor's basis becomes $700,000: $100,000 for their own half plus $600,000 for the inherited half. If the survivor sells for $1,250,000 with $75,000 in costs, the gain is $475,000.
| Sells within 2 years | Sells after 2 years | |
|---|---|---|
| Gain | $475,000 | $475,000 |
| Exclusion | −$500,000 | −$250,000 |
| Taxable gain | $0 | $225,000 |
Illustration only, assuming the same sale price in both cases. Not tax advice.
Without the step-up, the survivor's basis would be $200,000 and the gain $975,000.
Second homes and rental property
The home sale exclusion applies only to your primary residence. For a second home or a rental, the step-up is the main tax relief, and it can be worth a great deal.
Say a couple jointly bought a vacation home for $300,000 and it's worth $900,000 when one spouse dies. The survivor's basis becomes $600,000, so a sale at $900,000 produces about $300,000 of gain before selling costs. Without the step-up it would be $600,000.
For a rental, the inherited half gets a new basis, but depreciation taken on the surviving spouse's half still reduces that half's basis and can be taxed when you sell. Talk with your tax adviser before you decide whether to keep, rent, or sell.
Two things to do early
- Document the value on the date of death. A date-of-death appraisal establishes the stepped-up basis. It's much easier to get close to the date than years later.
- Mark the two-year date. If the primary home might be sold, know when the $500,000 window closes so the decision is yours to make.
Other situations worth knowing about
- You've rented out your primary home: rental use and depreciation change the calculation.
- You used the exclusion on another home recently: it generally can't be used more than once in two years.
- You're 55 or older: there's no extra exemption for age anymore. Is there still an over-55 home sale exemption? explains what changed.
What to do before you list
- Find your settlement statement from the purchase.
- Gather receipts and permits for improvements: additions, kitchens, baths, roofs, systems, windows.
- Get an estimate of your sale price and selling costs.
- Take all three to your tax adviser before you set a listing date.
I can give you the sale price and a seller net sheet for step 3. For more on planning a move around retirement, see how I approach retirement.