Many people sell their homes for more than they cost in the first place. If you are in this fortunate situation, and your home has appreciated in value, you could be required to pay capital gain taxes — not on the whole sale, but on the profit your home has earned for you over time.
☛ Homes are investments, offering an important path to financial independence. Read more about the appreciation of a home’s value on Deeds.com.
Now, the good news for many homeowners. The IRS allows the seller to exclude a significant amount of a home sale profit from capital gains tax. (Whew!)
This article offers general information on home sales and taxes for the homeowner who is planning to sell. Note that your state may regard some or all of your capital gains as taxable income. In this article, we focus on federal law and policy.
Capital Gains Are Taxable. Yet for Many Home Sellers, This Is Not an Issue.
When you sell a capital asset — like stocks, bitcoin, or a house — there’s tax on the profit. Depending on how long you held the asset before selling, the tax will be calculated on either short-term or long-term capital gains.
- Profits on assets owned no more than a year are short-term capital gains, taxed as regular income.
- Profits on assets owned for more than a year are deemed long-term capital gains, subject to a tax rate scale.
Many people keep their houses long enough for long-term capital gains to apply, which can help at tax time. To learn more about how much tax applies to a seller, refer to the fact sheet on capital gains and losses provided by the Internal Revenue Service.
But if you’re like many home sellers, the capital gains exclusion for sales of real property really saves your day. It can mean you pay nothing to the federal government. Here’s the rule: If you don’t do it more than once in a two-year period, you can sell your primary residence while excluding up to $250,000 in profit from federal taxes.
Each taxpayer, then, is spared capital gains tax on the first $250,000 of realized appreciation in value over the original purchase price. Couples filing jointly may double that exclusion amount for their co-owned house. Again, this is only for a primary residence, meaning the sellers will need to have owned the home for 24 months — two years of the past five (up to the closing date).
There are some exceptions that ease the residency rules. For example, homeowners transferring their home in a divorce have different timelines. Certain government and military personnel can put off their residency for up to ten years while deployed. If a deployed person lives at home for two out of the last 15 years, a profit on the home sale should qualify for the capital gains tax break.
And if the seller inherited the house, special tax rules apply.
To see more about the rules and exceptions to the rules, consult IRS Publication 523.
Pro tip: Investment properties can become primary residences, at which point they can benefit from the tax exclusion if sold. Here, it helps that the two-years-in-five residency rule means a total of two years — not necessarily two years in a row. But the gains accumulated while the home was in use as a rental property are subject to income tax.
How Can the Seller Offset Profits and Reduce Taxable Gains?
When you close your sale, your real estate professional or closing agent gives you IRS Form 1099-S for reporting proceeds from your real estate transfer. If you can exclude your profit from capital gains tax, advise your agent by Feb. 15 of the following year.
If it seems you’ve made a profit that puts you over the threshold, you might still be able to claim the exclusion, for a number of reasons:
- You can augment the cost basis of your home (what you paid for it) by adding in any fees and expenses involved when you bought it, including transfer taxes, title insurance, certain attorneys’ fees, and home upgrades that were operational or useful for at least a year.
- You can also offset the capital gains made in your home sale (or from the sale of your investment properties, which don’t benefit from the exclusion) with capital losses from other investments.
- Major losses can be carried over to future tax years to offset later expected profits.
For information on exactly how to adjust your tax basis, refer to IRS Publication 551: Basis of Assets.
Pro tip: If you give your home to another person, that transfer is not in the category of taxable sales, but gift tax may apply.
What’s the Tax Rate, When It Applies?
If your home sale brings a profit under $250,000 (or $500,000 for a couple filing jointly), you owe no capital gains tax. For profits over that exclusion threshold, look at your income to determine the percentage of that excess gain you must pay in taxes.
The basic rate categories (for the 2021 tax year) are as follows:
- Single filers earning under $40,400 (or joint filing couples with a combined income under $80,800) or heads of household who make up to $54,100 owe no taxes on long-term capital gains.
- Single filers who earn $40,401 to $445,850 (or joint filing couples with a combined income of $80,801 – $501,600), or a person filing as a head of household earning $54,101 to $473,750 is taxed at 15% on long-term capital gains.
- People with higher incomes pay 20% on long-term capital gains.
Here again, consult your tax professional to know how best to meet your tax obligations, including net investment taxes for high-income filers.
Pro tip: Taxable income is reduced when the property owner sells through a contract for deed. Here, the purchaser buys in installments, so the entire gain is not immediately realized. File IRS Form 6252 to report an installment sale every year in which the buyer makes payments.
The 1031 Exchange Can Be Used to Defer Capital Gains Taxes
Rentals and other investment properties don’t get the capital gains exclusion. Deferring (rather than eliminating) capital gains tax can be done, though. Section 1031 of the Internal Revenue Code outlines the rules of a like-kind exchange.
☛ How is it done? See For Property Investors: Six Steps to a 1031 Exchange on Deeds.com.
In what’s commonly called a 1031 exchange, an owner (which could be an incorporated business, partnership, LLC or trust, or simply a homeowner) sells a business or investment property. The proceeds then go to purchase another investment (“like-kind”) property. There are a number of rules and deadlines to meet. Following the legal rules means having experts on your side to facilitate the exchange. The capital gains tax exclusion can apply to an exchanged property later, after you have held in five years and lived in it two of those five years.
Speak with your tax expert before selling a property. This way, you’ll learn the most advantageous ways to offset your own capital gains. Each situation is unique, and your expert will check the up-to-date tax code to see what sections will impact your options. In some cases, tax experts may advise you to report gains as taxable, even when an exclusion applies. Your tax pro can also let you know if some deductions for depreciation on gains will count for the exclusion.
Meanwhile, knowing how home sale taxes work can improve your readiness when the time comes to sell your property.
Photo credits: Bailey Anselme and Maria Ziegler, via Unsplash.