Switched Keys

While enjoying a round of disc golf this week one of the players was talking about someone who had to live in a house he inherited for three years in order to avoid paying tax on the sale of the house. I may not have all the relevant details but it seemed confusing enough that I thought it would be a good idea to relay some tax information to others concerning home sales and a warning about tax traps.

Home Sale Tax Facts

There are three basic facts you should remember about home sales. The first thing should remember is that you only have to pay tax on the profit from a sale. The profit is based on the difference between the basis and the selling price. Generally, the basis is what the house was purchased for plus amounts paid for improvements. So, if you purchased the house at $75,000 and sold at $100,000, the profit would be only $25,000. It's only natural that you would make a profit on a home sale since inflation and appreciation increases the value of your home.

Secondly, current tax law allows owners to exclude $250,000 ($500,000 if married) of gain on a home sale. To qualify, the home must have been owned for two of the last five years, and used as a main home for two years out of the prior five years. So that taxable $25,000 becomes zero. Incidentally, that hasn't always been the case. See Income Averaging and Transitions in Tax Law for an interesting comparison with 1964 tax law.

Third, property inherited receives a basis equal to the fair market value of the home at the time of the decedent's death (with some exceptions). In this case, the heir would not qualify for the exclusion mentioned above since he didn't live there. However, even though he may not have paid anything for the house he inherited, his basis for calculating profit is the value at death, which should be close to the actual selling price. By definition, it's not likely that someone will purchase the house at very much over the "fair market value", so it should be rare to owe any tax on the sale. It's much more likely that you would be selling below fair market value just to get it sold.

Most people probably understand that you only pay tax on the profit, but many will not know about the exclusion or the treatment of inherited property. Of course, there may be other aspects of the sale to consider, but remembering these three facts may come in handy for you or someone you know. 

Tax traps

There are many tax traps where you are liable for taxes you didn't know about, but there's probably more "traps" that involve taxes you paid that you didn't have to or credits you didn't claim.

Education Tax Credits

For many years people, including many tax preparers were not aware of the benefits of education credits. You may think that's just for low-income taxpayers, but if you make less than $80,000 ($160,000 joint), you could qualify for up to $2500 in AOTC, often even if you received financial aid, and even if you didn't pay anything out of pocket. Plus, there are several other tax credits.
Education Tax Credits were so overlooked that I wrote a book on the subject two years ago. See Education Tax Credits. A few things have changed (technically) since then, but the credit is essentially the same. For example, you now have to have a 1098T, but the institutions will now have to provide one to you. If they don't you can still claim as if they did. You can see a summary article at Education Credits: Beyond the Basics.

Inherited IRAs

One of the basic concepts of inheritance of property is that it gets a step-up in basis which usually means no taxes. Although inherited property gets a step-up in basis, if you receive an IRA as an inheritance, it is taxable and there is a significant penalty for cashing it in. There are other rules related to IRA management, and the institution may not warn you about them. Read more about Common IRA Traps. 

You can amend

Yet another thing that many people are not aware of is that taxpayers can normally amend (change) their tax returns for up to three years to get benefits they didn't claim when they first filed. Of course, there are some things you can't easily change with an amended return, such as uncashing in an IRA distribution.

In many tax cases you can consult a tax professional, but in some cases it may not be enough to consult one or two professionals. If it involves a large amount or tax, research it yourself and ask a lot of questions. Start with googling if you want, but refer to taxpayer publications or the tax code to verify what others are saying. Don't blindly rely on a website or even a tax preparer. Many times the tax forms and instructions will guide you through the calculations, while tax preparers way speedily just fill in the blanks.