This principle happens to overlap with a tax rule that may affect homeowners who are considering selling their homes within five years of purchase. We’ll address the tax implications further down.
The five year rule is not hard and fast — in fact, some real estate agents don’t even refer to it as such. But there are several factors to consider when selling your house within five years of purchasing it.
How do I decide if the 5 year rule applies to me?
Allen Studebaker, a top real agent in Scottsdale, Arizona, who works with over 71% more single family homes than the average Phoenix area agent shares information to help homeowners decide if it’s worth it to make a move from their primary residence in less than five years.
When it comes to buying and owning a home, the general advice is that it will gain more value the longer it is owned by the same owner, especially if the area where it’s located is growing or becoming more sought after. This is known as appreciation, and it comes from a variety of factors that influence one another to drive home values upward.
When owners need to sell their home in a shorter time frame, how to determine if the sale is worth pursuing can be confusing. That is where the five year rule comes into play.
So what factors should be considered when you’re wondering if your home’s value has appreciated in the time you’ve owned it?
Some common factors that increase a home’s value include:
- Supply and demand
- Comparable properties nearby (known as real estate comps)
- Size and usable space of your home
- Age and condition of your home
- Upgrades and updates
- Health of the economy
- Generational needs
- Walkability score
“The key thing for people to do is to gain knowledge of their market,” says Studebaker.
A major factor in seeing if the five year rule applies is the current appreciation rate for homes in your area. The appreciation rate in the United States can vary wildly. In 2022, the average appreciation rate is 14.5%, while it was only 4% in 2019.
Use HomeLight’s online Home Value Estimator to find a ballpark estimate of your home’s worth right now. This free tool will give you an idea of what your home’s value is in real time, compared to the purchase price, so you can gauge the appreciation.
What if I need to sell my home before five years?
Sometimes the need to relocate less than five years after purchasing a home cannot be avoided. Life happens, but there are options other than selling to help you build up enough equity in your home before putting it on the market.
A common option for people who do not yet want to sell their home before owning it for five years is to turn it into a rental property. Renting it long-term, or even renting it out as a short-term vacation rental are options that you can consider to put off selling it while still gaining income from owning it. “A lot of the cash offers are from investors that are coming in and know what’s going on with rent rates,” says Studebaker.
Vacation homes do well in states like Studebaker’s market, which is in a year-round warm part of the country. “Unlike some of the cold weather states, we have a lot of vacation rentals here,” Studebaker says. “So right now, in Arizona, it’s 65 degrees and sunny but in the Midwest, it’s snowing, and in the northwest, it’s raining. Those folks are coming here to enjoy our winter weather.”
The other 5 year rule: Tax implications for selling your home
One way the IRS taxes capital gains from a home sale is based on whether or not the property has been owned long term or short term. This helps separate the average homeowner from investors. Average homeowners generally sell their homes in order to move, upsize, or downsize. Investors buy and sell homes annually for a profit, which counts as income.
For the average person, figuring out taxes on a home sale can become complicated because the IRS considers your home a capital asset and can be subject to capital gains tax. This means you may be required to pay taxes on profits you make from the sale if your home has appreciated in value. There are capital gains exemptions that may apply, which is where the five year rule can be beneficial to homeowners who follow it.
The IRS offers a capital gains tax write-off for homeowners, but it depends on how long you owned the home, how long it was your primary residence, your filing status, and the amount of the profits from the sale.
You must have lived in the home as a principal residence for any two of the five years before selling. If that condition is satisfied, up to $250,000 of profit is typically considered tax free if you’re a single filer — or up to $500,000 if you are married and file jointly. Profits over these amounts must be reported as a capital gain that is subject to taxation, generally. But a tax professional can give you the best view of your options.
In a market with less homes available for sale — a seller’s market — the increased demand can make the sale price go above its list price, which means bigger profits for some homeowners. In a seller’s market, being knowledgeable on the tax implications is more important than ever.
“What we’re looking at is an extreme shortage of inventory,” says Studebaker. “It’s putting a lot of pressure on our market, which obviously, supply and demand is driving the home prices up significantly and we don’t see that changing for at least the next three years. It could be as long as five years before we see a change in inventory.”
Testing the 5 year rule: How much does it cost to sell my home?
If you’ve purchased a home within the past five years, you may remember the costs associated with purchasing it, from inspection fees to closing costs. These costs can add up, and will also factor into whether or not it’s worth it to re-sell within five years, since most people who sell their home often need to purchase a new one to live in too. To make money on your home sale, it needs to have appreciated in value more than the sum of all the selling fees you will face when moving.
Your costs will vary depending on the condition of your home, and the availability of homes for sale in the market in which people are buying.
Common costs associated with selling your home include:
- Staging fees and costs to prep the house for showing (varies)
- Realtor commissions for the sale (5% – 6% is standard)
- Inspection and repair fees (varies)
- Closing fees to sell, which include title fees, transfer taxes, escrow fees, recording fees, and prorated property taxes (1% – 3% of the sale price)
- A possible second set of closing costs if buying a new home
- Seller concessions (2% – 6%)
- Overlap costs (1% – 2%)
- Moving and relocation costs (varies)
- Mortgage payoff (varies)
One of the things that homeowners need to think about is what your strategy will be on how you’re going to get to the next house. Some people are upsizing, some people are relocating, some people are downsizing. They really need to get with a professional and put together a plan because with inventory as low as it is, you need to have a strategy on how you’re going to make that next move.
Beating the 5 year rule: Get experts involved
“One of the things that homeowners need to think about is what your strategy will be on how you’re going to get to the next house,” says Studebaker. “Some people are upsizing, some people are relocating, some people are downsizing. They really need to get with a professional and put together a plan because with inventory as low as it is, you need to have a strategy on how you’re going to make that next move.”
Your CPA or tax professional is a valuable person to consult when you’re thinking about selling your home in less than five years after purchase. A tax professional who is familiar with your financial situation can be an extremely useful tool in analyzing if selling would be beneficial or cause undue expenses.
It’s important to think about how long you want to live in a house before you make a purchase, because there are many benefits to following the five year rule. Losing money on a home purchase is never the goal, so make sure it’s the right choice before signing on the dotted line.
Partner with an experienced agent to truly evaluate the 5 year rule
When it’s time to buy your next home, use HomeLight’s Agent Match tool to find and partner with a top agent.. No matter how long you have lived in your home, our data shows that the top 5% of real estate agents across the U.S. sell homes for as much as 10% more than the average agent.
If you are looking to sell your home and relocate, ask yourself where you want to be in five or 10 years from now. Ultimately, the five year rule is a good guide for the average homeowner to help get the most out of where you live now, and give you the best return when the time comes to sell and move on to your next home.
Header Image Source: (Phillip Long / Unsplash)