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When you sell a rental house, you may have to pay capital gains taxes if you make a profit from the transaction. However, the Internal Revenue Code also provides an Ownership and Use Test that may get you off the hook, even if the sale leaves you with more money in your pocket than you paid when you bought the house.
About Capital Gains
The Internal Revenue Service says that almost everything you own for personal use or investment gain, such as a rental house, is a capital asset. When you sell any of those assets for more than they cost you, the difference in pricing is a capital gain. If you sell it for less than what you paid, you have a capital loss. You must report all your capital gains in your tax returns, as they may be taxable. Capital losses from the sale of investment properties are deductible, but not the losses resulting from the sale of your residence.
Ownership and Use Test
The IRS' Ownership and Use Test establishes whether you may call your rental house a primary residence. If you can, you may be able to avoid paying capital gains taxes when you sell it. According to the IRS, your investment property qualifies as being for personal use if you owned the home and lived in it for at least two years -- continuously or not -- in the five years preceding its sale date. Unless your property passes this test, you must pay capital gains taxes when you sell your rental house for a profit.
If you determine that your rental house was not a primary home for you (in other words, you did not live in it for two years) you must pay capital gains taxes on your gains. If you determine that your rental house is also a primary home as far as the IRS is concerned, however, you are not off the hook yet -- you must still calculate whether you owe taxes from its sale. The IRS rule that applies in this situation says that you will pay capital gains taxes on any profit you make over $250,000 if you file your return as a single individual. If you file under a married status, only profits over $500,000 are taxable.
Reporting Real Estate Gains
If your rental house qualifies as a primary residence and its sale brings $250,000 or less -- or no more than $500,000 if you file a joint tax return -- in profit, you do not need to declare the sale on Form 1040. If your profit is higher than the limits the IRS establishes, complete Schedule D, providing the financial details of the sale. Write down the amount of capital gains you received on line 13 of Form 1040 and submit both IRS forms when filing your return.
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