Are you considering downsizing your home?

Maximize Your Savings: Tax Considerations When Downsizing Your Home

Are you thinking about moving into a smaller house or relocating to a more affordable neighborhood? Downsizing can offer plenty of financial benefits, from lower monthly expenses to potential extra cash from the sale of your home. However, before making this big move, it's essential to understand the tax implications that could affect your finances. In this post, we'll explore key tax factors to consider before selling your home.

Key Financial and Tax Benefits of Downsizing

Downsizing your home might reduce maintenance costs and lower your property taxes. It can also unlock equity, allowing you to invest or boost your retirement savings. But taxes could eat into your profits if you're not careful. Before you make any decisions, here are essential tax rules you should know about selling your home.

1. Capital Gains Exclusion on Home Sales

One of the biggest tax advantages when selling your primary residence is the capital gains exclusion. Under current law, if you sell your home for a profit, you may exclude up to $250,000 in capital gains if you're single, or up to $500,000 if you're married and filing jointly. This exclusion can save you a substantial amount in taxes.

Ownership and Use Tests

To qualify for the maximum exclusion, you must pass the **ownership and use tests**:

- Ownership: You must have owned the home for at least two years.

- Use:  You must have lived in the home as your primary residence for at least two out of the last five years.

If your home has appreciated significantly, understanding this exclusion is crucial, as failing to meet the

Exceptions to the Rule

There are exceptions to the two-year ownership and use tests. For example, if you need to sell due to a job change, divorce or an unforeseen circumstance (like a natural disaster), the IRS may allow a prorated exclusion. You can claim the exclusion on multiple home sales, but only once every two years.

2. Calculating Your Cost Basis

Your cost basis plays a pivotal role in determining how much of your home sale is taxable. To calculate your capital gains, subtract your cost basis from the selling price of your home.

The cost basis is not just the price you paid for your home. It can include certain allowable expenses, such as:

- Settlement fees and closing costs

- Real estate commissions

- Significant capital improvements (e.g., renovations, a new roof, home additions)

These adjustments can increase your cost basis, thereby lowering your taxable profit. However, some factors may reduce your cost basis, such as energy-related tax credits or any home office depreciation you claimed over the years. Keeping accurate records of these expenses is critical to minimizing your tax liability.

3. Capital Improvements vs. Repairs: What Counts?

Tax rules allow you to add the cost of capital improvements to your cost basis, but not the cost of repairs. A capital improvement is anything that adds value to your property, such as installing a new roof or building a deck. Repairs, on the other hand, simply restore the home to its original condition (e.g., fixing a leaky faucet), and they cannot be added to your cost basis.

Example: Jon and Jane’s Tax Bill

Let’s walk through an example to illustrate how these rules work.

- Home purchase price: $250,000 (purchased in 1988)

- Home sale price: $875,000

- Cost basis adjustments: $12,500 in settlement fees and closing costs, $85,000 in capital improvements

Cost basis:

$250,000 (purchase price) + $12,500 (fees) + $85,000 (improvements) = $347,500 – $50,000 (depreciation) = $297,500.

After subtracting their cost basis from the sales price, Jon and Jane will realize a capital gain of $522,500. Since they’re married and filing jointly, they can exclude up to $500,000 of that gain, leaving them with a taxable capital gain of $22,500. Their long-term capital gains tax rate is 15%, meaning their total tax bill will be $3,375.

They will also have to pay $12,500 to recapture the depreciation on their home office, taxed at 25%.

4. What If You Choose to Rent Instead?

If downsizing means you won’t buy another home, renting can provide certain advantages. For instance, you'll no longer have to worry about property taxes, property insurance and home maintenance, which can significantly reduce monthly expenses. However, keep in mind that renting doesn’t allow you to build equity, and rent prices can fluctuate based on the landlord’s decisions.

Renting might also offer you more flexibility to travel or relocate in the future, but you’ll need to weigh the pros and cons based on your financial goals and personal preferences.

Final Thoughts

Selling your home and downsizing can be an excellent way to reduce expenses and unlock cash, but it’s essential to be mindful of the potential tax implications. By understanding the rules around capital gains exclusions, cost basis adjustments, and depreciation recapture, you can make informed decisions that maximize your financial benefits.

Before making any major decisions, it’s always a good idea to consult with a **financial advisor** to discuss your unique situation and ensure you’re making the best choice for your financial future.

FAQ on Downsizing and Taxes

1. How often can I claim the capital gains exclusion on a home sale?

   You can claim the exclusion once every two years.

2. Do capital improvements include home repairs?

   No. Only improvements that increase the value of your home count, such as renovations or adding square footage.

3. What is depreciation recapture?

   If you’ve claimed a home office deduction, you may need to repay taxes on the depreciation when you sell.