Don’t Overlook This Loophole When Tax Planning in Retirement

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A realtor will always tell you it’s a great time to sell your home, but in this current environment, they may actually be correct. The housing market is on fire lately and homes are being snatched up well above asking price. With interest rates expected to remain low for the foreseeable future, sellers should have no trouble continuing to find buyers. However, it’s important not to do so without first considering how a sale will fit into your tax plan.

For recent or soon-to-be retirees, the current market makes now a great time to downsize and find a smaller, more manageable home to enjoy during your retirement years. Although you always want to make sure you get the maximum value for your home, it can be especially important to make sure that as much money as possible ends up in your pocket when you’re using proceeds from your home sale to cushion your retirement savings.

One way to accomplish this is by reducing the taxes you would owe on profits from the sale of your home. The federal government offers a tax break that can save sellers thousands of dollars: the primary residence exemption.

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What Is the Primary Residence Exemption?

In 1997, Congress passed the Taxpayer Relief Act, which lowered certain taxes and introduced new tax credits for middle- and lower-class Americans. Capital gains taxes were reduced across the board and many popular programs like the Roth IRA, child tax credit, and education credits were established.

One of the biggest beneficial breaks came to homeowners. Under the Section 121 exclusion, single homeowners can deduct $250,000 of capital gains from the sale of a house as long as that house was their primary residence. For married couples filing jointly, the exclusion is increased to $500,000. There are certain restrictions to this exclusion that we’ll discuss later, but getting a tax break on the first $250,000 of capital gains is a significant boost for most homeowners.

For example, let’s say a homeowner named Michael purchased his home in 2016 for $200,000. Thanks to a boom in the downtown area, Michael’s home value increased from $200,000 to $350,000 in just under four years. After accepting a new job out of the state, Michael decides to sell his home and reaps a $150,000 capital gain. Thanks to the primary residence exemption, Michael won’t owe a penny in capital gains taxes on the sale.

Rules and Limitations of the Primary Residence Exemption

In order to qualify for this exemption, you’ll need to meet certain qualifications. First and foremost, this exemption can only be used once every two years. If you have two homes and sell them both within a two-year span, you can only claim the exemption on one of the sales. Plus you’d need to pass the eligibility test.

The eligibility test is a five-step process used to determine whether a home sale qualifies for the primary residence exemption. The eligibility test is used to disqualify property owners from using the exemption on multiple sales over a short time period. The five steps to determining eligibility are:

●      Step 1: Automatic Disqualification – If the home was acquired in a 1031 exchange (one property swapped for another) or you are subject to the expatriate tax, you will be automatically disqualified from using the exemption.

●      Step 2: Ownership – You must have been the owner of the home for at least 2 of the preceding 5 years. The years do not need to be consecutive, but you must have spent at least 24 months owning the home during the 5-year period. For married couples, only one spouse needs to claim ownership of the home to qualify for the exemption.

●      Step 3: Residence – Here’s the step that trips up a lot of people. In order to qualify, you must have spent 730 days residing in the home in the last 5 years. Like the ownership requirement, consecutive days in residence don’t matter but the 730 day total must be met in order to have the home qualify as a ‘primary residence’. For married couples, both spouses must meet the 730-day requirement in order to get the full tax break.

●      Step 4: Look Back Restrictions – Did you claim the exemption on the sale of another home in the last 24 months? If yes, you would need to wait a full two years in order to claim the exemption again.

●      Step 5: Exceptions – Like all government programs, exceptions to the rules exist. For example, members of the armed services away on active duty can waive the two-year residency requirement if their service prevented them from living in the home. For more examples of exceptions to the eligibility test, see Publication 523 on the IRS’s website.

Partial Exclusions Under the Primary Residence Exemption

If you fail the eligibility test, don’t give up – you still may be able to claim a partial credit on the capital gains tax exclusion for primary residence sales. The IRS lists three main reasons for home sellers to claim a partial exclusion under the primary residence exemption:

  1. Work-Related Move – If you had to sell your home because you needed to move for employment, you can claim a partial exclusion if the new work location is more than 50 miles further away from the home than the old work location.
  1. Health-Related Move – If you move to care for a sick relative or receive treatment for an illness of your own, you may qualify for a partial exclusion. Additionally, if a medical professional suggests a move due to health concerns (ie. selling a house to move into an assisted living facility), a partial exclusion may be on the table.
  1. Unforeseen Circumstances – If your previous home was destroyed by a natural disaster or otherwise condemned, you may qualify for the partial exclusion. Additional circumstances where the exclusion might apply include death, divorce, loss of job, or a lack of ability to pay for basic living expenses.

You’ll need to claim the capital gains on your tax return regardless of whether you take the exemption or not. There may even be certain instances where you wish to forgo the exemption altogether. Before claiming the primary residence exemption (or any other special tax break), be sure to consult with your advisor and make sure it fits into your overall financial plan.

Tax Planning with Advanced Retirement Strategies

Unfortunately, many CPAs do not assist with tax planning. They can be relied on to prepare your taxes in April, but they seldom have an opportunity to consult with their clients on how they can financially plan for the coming year from a tax efficiency perspective.

That’s where Advanced Retirement Strategies comes in. Our team of experienced professionals are available to help clients make the most of their retirement income through careful tax planning.

Contact us today to learn more about how you can make the most of your golden years by partnering with Advanced Retirement Strategies.

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