Capital Gains Tax and Selling Your Home

Personal Finance

Sep 19

Capital Gains Tax on Real Estate & Home Sales Vision Retirement investing RIA CFP investment management Ridgewood NJ Poughkeepsie NY

Capital gains tax is part and parcel of some home sales, which can be incredibly disheartening for those who expect to receive a significant profit and add this money to a retirement fund—or spend it elsewhere!

Keep in mind, however, that scenarios do exist whereby you can minimize these fees (or avoid them altogether!). This article discusses the same with some key facts to know about capital gains tax.

What is capital gains tax?

Capital gains tax must be paid on profits earned whenever you sell an asset. While you’ll most likely hear about this requirement when selling property, it also applies to stocks, bonds, and other assets.

No matter the asset you decide to sell, know you’ll only be taxed on any “gains” (profit earned via the sales process) rather than on the entire sale price itself. For example, if you initially purchased a property for $250,000 and later sell it for $450,000, you’ll only be taxed on your $200,000 profit.

How much do I have to pay in capital gains tax?

The amount of money you’re expected to pay varies depending on various factors including:

· The gains (profit) made on the sale

· Length of property ownership

· Personal circumstances (taxable income bracket)

Short-term capital gains tax will likely apply if you’ve owned your property for less than two years—meaning you’ll be taxed at a rate similar to your current tax bracket (or as high as 37%)—whereas long-term capital gains tax applies to property owned for a longer period of time. This is often beneficial to the seller, as the tax rate is typically lower on long-term assets and runs between 0% and 20% (based on income). Here’s what you’d pay based on 2024 capital gains tax rates (as published by the IRS):

To illustrate, let’s assume you sell a home for $500,000 and capital gains is due on $100,000 of your sale. If you’re married and filing jointly and your taxable income is $200,000, you’d pay a 15% (or $15,000) capital gains tax on the sale of your property.

How to minimize (or avoid!) capital gains tax

In some cases, a Section 121 exclusion may allow you to reduce the amount of capital gains tax owed: allowing (unmarried) single filers to exclude up to $250,000 of capital gains, with this figure rising to $500,000 for those who file a tax return with a partner as a married couple. Specific boxes must be ticked, however, to qualify for this exclusion…

The property must be your principal residence

To apply for a Section 121 exclusion, the property for sale must be considered a primary residence; anyone selling a rental or vacation home generally won’t qualify for capital gains tax exemptions. Nevertheless, you may be able to use this exemption on such properties if you at one point converted the home into a principal residence per the time period outlined below.

You must have owned (and lived) in the home for at least 2 years

It’s important to note this exemption applies only if you’ve owned and lived at the property for at least 2 years over a 5-year period (up to the date of sale), also known as the “2-in-5 Year Rule.”

However, this does not mean you must have occupied the property for two consecutive years in order to qualify (vacations don’t count against you). Per IRS guidelines, sellers must simply be able to prove they completed a “total of 24 months (730 days) of residence during the 5-year period.” You’re generally required to present some type of “proof” you’ve met this prerequisite such as a driver’s license, tax returns, or utility bills with the same address.

One exception to the 2-in-5 Year Rule, however, is if you’re in the military on extended duty (lasting more than 90 days) and serving at least 50 miles away from your primary residence or living in government quarters. Under this scenario, you can choose to defer the 5-year requirement for up to 10 years while on duty; so long as you occupy the home for two of 15 years, you’ll qualify. This exception also applies to some government officials who meet similar requirements.

In the event of a divorce, meanwhile, the spouse granted ownership of the home can include the years his/her ex-spouse owned it (or lived there until the sale date) to qualify.

You cannot have purchased the home via a like-kind exchange

Sometimes called a “1031 exchange,” a like-kind exchange is the process of using the proceeds from a business or investment property sale to buy a similar property: a strategy often used to postpone capital gains tax. You won’t qualify for the tax exclusion, however, if you’ve done this within the last 5 years.

You can’t be subject to expatriate tax

If you renounce your U.S. citizenship or residency status as a result of living abroad for an extended period of time, the IRS could levy an expatriate tax (based on your net worth and other related factors) and thus disqualify you from the capital gains tax exclusion.

You didn’t already use the exclusion within the last 2 years

If you’ve already utilized an exclusion for a home in the 2-year period before the sale of your current one, you’re ineligible to take advantage of this subsequent opportunity.

Additional ways to defer, reduce, or avoid capital gains taxes

While the above exclusion is perhaps the most straightforward way to lower capital gains taxes, you can take several other steps to reduce the amount you pay. This includes…

Making home improvements

Make sure to save any receipts from capital improvements—any permanent addition or alterations that add value to your home—as they can help reduce the amount of taxes you owe. Examples include replacing a roof or installing an HVAC system, pool, or fence. Visit the IRS website for additional examples.

Capital improvements ultimately impact your cost basis: the price you paid for the home and the capital improvements you’ve made. For example, let’s say you purchased your home for $400,000 and eventually sell it for $700,000 (meaning you’d pay a capital gains tax on the $300,000 profit); if you’ve made $100,000 in capital improvements, however, you’d only be taxed on $200,000.

Qualifying for an exception

Exceptions do exist to help you exclude a larger chunk of your capital gains, including one for surviving spouses. For example, if you purchased a home with your partner and sell it within 2 years of his/her death, you may be able to increase your tax-free allowance from $250,000 to $500,000: proving this is your primary residence and that you’ve lived there for at least 2 years in order to do so (note you’re not eligible for this form of tax relief if you’ve remarried by the time the sale takes place).

Visit the IRS website for a complete list of exceptions to qualify for maximum capital gains tax exclusions.

Final thoughts on capital gains taxes and your home

Capital gains taxes are likely one of the more costly expenses incurred during the sale of a property—though it does largely depend on its value and how much you stand to make. It's important to note, however, that you can significantly reduce (or even eliminate) these costs by following the guidance shared herein.

Still have questions about capital gains tax? Schedule a FREE Discovery call with one of our CFP® professionals.

FAQs

Taxes for tax-advantaged accounts such as 401(k)s, 403(b)s, IRAs, 529s, and health savings accounts (HSAs) are typically triggered only when making withdrawals.
The spouse who chooses to remain in the home is only subject to capital gains tax when he or she decides to sell, with the ability to exclude the first $250,000 in profits from taxes after the sale is complete (provided he or she lived there for at least 2 years previously). If the spouse remaining in the home eventually decides to remarry, meanwhile, the $500,000 exemption is once again a possibility provided the newly married couple owns and lives in the home together for at least 2 years.
The math behind your gain or loss is simple. First, take the sales price and subtract any related expenses (e.g., real estate fees and closing costs). The net result is the “amount realized,” which you then take and subtract your “adjusted basis” from—the result is your capital gain or loss.
Your adjusted basis is generally the amount you paid for your home plus the cost of any capital improvements you’ve made, minus any returns such as home insurer payments.
Unfortunately, you’re not allowed to do this (nor treat the sale as a capital loss on your income taxes).
While a law for seniors aged 55+ once provided a one-time exclusion of $125,000, it expired back in 1997 and was replaced by the current $500,000 exclusion cap.