No, buying a smaller home has no impact on your taxes; however, the sale of your original house may.
If you have a capital gain from the sale of your Primary Residence, you may qualify to exclude up to $250,000 of that gain from your income if single, or up to $500,000 of that gain if you file a joint return with your spouse.
In general, to qualify for the exclusion, you must meet both the ownership test and the use test.
- You're eligible for the exclusion if you have owned and used your home as your main home for a period aggregating at least two years out of the five years prior to its date of sale.
- You can meet the ownership and use tests during different 2-year periods. However, you must meet both tests during the 5-year period ending on the date of the sale.
- Generally, you're not eligible for the exclusion if you excluded the gain from the sale of another home during the two-year period prior to the sale of your home.
- Refer to Publication 523 for the complete eligibility requirements, limitations on the exclusion amount, and exceptions to the two-year rule.
If you receive an informational income-reporting document such as Form 1099-S, Proceeds From Real Estate Transactions, you must report the sale of the home even if the gain from the sale is excludable.
Additionally, you must report the sale of the home if you can't exclude all of your capital gain from income.
IRS Topic - Sale of Home
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