Capital Gains From a Home Sale—Is it Taxable?
Capital Gains From a Home Sale—Is it Taxable?
Congrats! Your house is selling for substantially more than you paid for it! That’s a good thing… or is it? The IRS may want a chunk of the profits in the form of capital gains tax. There are some scenarios when selling a home will generate a tax liability. But there are ways that homeowners can avoid taxes of home sales.
What are Capital Gains?
Belongings of significant value are considered “capital assets.” They include things like stocks and bonds and also tangible property like cars, boats, and houses. Selling a capital asset results in a capital gain if it is sold for more than its purchase price. If it is sold for an amount less than what it was bought for, it is a “capital loss.”
The IRS requires taxpayers to report capital gains on their federal income tax returns. Some states do, too. In most cases, capital gains are taxable. Most home sales, however, are excluded from capital gains tax. As long as a homeowner meets certain IRS requirements, they could be exempt from all or some tax.
Calculating Capital Gain Amounts
It’s important to understand how the IRS calculates the amount of a capital gain. The first important number in the formula is the cost basis. The cost basis is the original purchase price of the house, plus certain improvements made over the course of ownership. The IRS has a list of improvements that qualify.
Let’s look at an example of a home that was purchased for $120,000. Over time, the owner made improvements that cost $30,000. The cost basis of the home is $150,000.
The owner sells the house for $250,000. Commissions and fees add up to $5,000, so only $245,000 is actually received. The amount of capital gain is $95,000 ($245,000 minus the cost basis of $150,000).
Calculating Taxes of Home Sales
The capital gain of $95,000 in our example is not taxable, and in fact, doesn’t even need to be reported to the IRS. That’s because the IRS excludes up to $250,000 in capital gains for single taxpayers and up to $500,000 for taxpayers who are married and filing jointly. That means there would have to be a huge profit on a home sale to be subject to capital gains tax, as long as the house and the homeowner(s) meet certain criteria.
One note about the $500,000 threshold: Until recently, if one spouse passed away, the $500,000 threshold would only apply if the house was sold right away. If the surviving spouse did not sell the home in the same year as the spouse’s death, the threshold would drop to $250,000. The new law allows the surviving spouse to take the $500,000 exemption for two full years after the death.
Who Has to Pay Capital Gains Tax on Home Sales?
A capital gain that is less than the threshold of $250,000 or $500,000 is not a guarantee that a homeowner is off the hook for taxes. The IRS has very specific requirements that must be met in order to be exempt.
The seller must own the house for at least two years before selling it, otherwise, the capital gains will be taxed. If the timeframe is less than one year, the amount is subject to short-term capital gains tax, which is typically a higher tax rate than long-term capital gains tax. We’ll discuss tax rates in a moment.
The two-year ownership rule can be costly for people wanting to fix up and “flip” houses quickly for a profit. The amount of capital gain can be reduced by the improvements they make on a fixer-upper, but that also cuts into their profits, which is the whole purpose in flipping houses.
The home must be the seller’s primary residence for at least two years. Those years don’t have to be consecutive, but they must occur within the five years leading up to the sale.
This may not sound like a big deal—unless the home is a rental property or vacation home. Consider someone who decides to move in with a boyfriend or girlfriend, and rather than selling their home, they rent it out. If they decide to sell at a later date, the amount of time that has passed becomes significant. Ideally, they should sell within the five-year window or they’ll be responsible for the tax on the capital gain.
Again, “two” is the magic number. If a homeowner has been exempt from paying capital gains tax on another home sale within the past two years, they can’t take the exemption again. This is more generous than the old rule. Up until 1997, a one-time exemption was allowed, but only to people over 55. Now, taxpayers can move every two years and be exempt from capital gains tax every time.
How Much Will You Pay?
If a homeowner fails to meet one of the IRS standards they will have to pay capital gains tax. The tax rate depends on whether they are short-term or long-term capital gains.
Short-term capital gains tax applies to properties sold within one year of being purchased. Essentially, the gain is treated like any other income and is taxed at the same rate as the taxpayer’s marginal tax bracket.
Long-term capital gains tax is charged on properties held for more than one year. The rate is calculated as either 0%, 15%, or 20%, depending on the taxpayer’s filing status and taxable income.
If a homeowner meets all of the IRS criteria, but their profit exceeds the threshold ($250,000 for singles and $500,000 for married filing jointly,) they will owe long-term capital gains tax on the overage. For example, if a married couple sells their home for $600,000 more than their cost basis, they will pay tax on $100,000.
Ways to Reduce or Eliminate Capital Gains Tax
There are some things homeowners can do to mitigate the impact of capital gains tax.
Be Aware of the Timeline
If a homeowner is just a few months shy of the two-year ownership mark, knowing the rules could make a big difference. It might be a significant savings to wait it out before putting the house on the market.
Keep Good Records
Capital improvements made to a house can make a big difference in calculating the cost basis, and therefore the amount of capital gain. The IRS will need proof of upgrades and additions. Keeping track of expenses for any major improvements can help reduce the chances of having to pay capital gains tax.
Ask About Exceptions
There are some exceptions to the IRS rules for capital gains tax. In some cases, a home sale that is necessary due to losing a job or because of an illness might qualify for a special exemption.
Knowing the rules is one of the most important things a taxpayer can do to avoid a surprise at tax time. Each new tax year certain tax laws, rates, and taxable amounts change. It is best to visit the IRS website or talk to an accountant about how current tax laws will affect your tax liability.
Of course, this is an issue only if you manage to sell your home for more than you paid for it. Getting to that point takes a knowledgeable real estate expert. The agent at Berkshire Hathaway HomeServices Select Properties can get you there.
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