Avoiding Taxes 101: Sell Your House

“Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.”[1]

If you pay less tax on the money you earn, you get to keep more of it. That’s a pretty simple concept. The more complex problem is finding a way to protect your earnings from taxation, both at the federal and state level. Over the course of the next few newsletters, I am going to introduce you to a few ways to avoid paying taxes on your earnings. To avoid boring you to sleep, these discussions will be brief and merely highlight the issues. My goal is to simply get these concepts on your radar. If the strategy might work for you, follow up with your accountant or give me a call and we can have a more in depth discussion.

The first strategy: sell your house and buy a new one. A great way to avoid income tax, at both the state and federal levels, is through the sale of your personal residence. To qualify under both federal and state law, you must have owned and resided in your home for at least two of the five years before the sale. If you meet these ownership and residence requirements, you are eligible to exclude the gain from the sale of the property under the Principal Residence Exclusion.

The exclusion is capped at the federal level: single taxpayers are entitled to a $250,000 exclusion, and married taxpayers filing jointly are entitled to a $500,000 exclusion. Pennsylvania offers an unlimited exclusion, so the gain is never subject to state tax. The exclusion is available once every two years, and there is no limit on the number of times you can take it. If you cannot meet the residence requirement because of a special circumstance, you still may be eligible for a partial exclusion. Examples of special circumstances include a change in health and a change in employment that requires you to move more than fifty miles.

Here is a quick-simplified example. Harry and Sally, Pennsylvania residents, bought a house for $200,000. The couple owned and lived in the home for fifteen years. Now that the kids have left the nest, they want to downsize. If Harry and Sally sell the house for $250,000, they can claim the Principal Residence Exclusion, and the $50,000 gain (the selling price less their investment) will not be taxed at either the federal or state level. The $50,000 tax free gain can then be reinvested in a new home or in alternative assets. If the couple gets tired of the frigid Pennsylvania winters and decides to sell their new downsized home and move to Florida, they can take advantage of the exclusion again, as long as they meet the residence and ownership  requirements (2 years each).[2]

One caveat: this strategy only works if the sale of your house will generate a gain. Losses from the sale of personal use property, including homes, are not deductible and may not be used to offset other capital gains. If you are in a financial position to do so, converting your home to rental or business property (specific criteria must be met) can provide an avenue for capturing these losses.

The Principal Residence Exclusion is a great way to avoid taxes. As the real estate market recovers and home values begin to appreciate once again, keep the exclusion in mind if you are considering making a move. Next time, I will give you a second way to avoid taxes through a property transaction called a like-kind exchange, which simply involves trading your investment or business property for a new one.

[1] This quote endorsing legal means of tax avoidance through smart tax planning (as compared to illegal or fraudulent means) was penned by the great Judge Learned Hand in the case of Gregory v. Helvering. Besides providing us with an excellent mantra, Judge Hand also had one of the greatest judicial names of all time.

[2] If Harry and Sally purchase a new home in Florida, the exclusion may be used again subject to the ownership and residence requirements. The same rules discussed above will apply to the federal exclusion; however, Harry and Sally would have to look to Florida state law to determine whether any of the gain could be excluded in Florida.

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