Selling a home at a high price can be an exciting prospect, but it’s important to be aware of the potential tax implications.
Capital gains on real estate can be taxable, meaning you may have to pay taxes on the profit you make from the sale.
However, there are strategies you can employ to minimize or even avoid a tax bite on the sale of your house. In this article, we will explore how capital gains taxes work on real estate, when you might be liable to pay them, and how you can minimize your tax liability.
Understanding Capital Gains Taxes on Real Estate
When you sell a house for more than what you paid for it, you could be subject to taxes on the profit you make from the sale.
This tax on the profit is referred to as capital gains tax. The good news is that many people can avoid paying capital gains tax on the sale of their primary home because of an IRS rule that lets you exclude a certain amount of the gain from your taxable income.
To qualify for the home sale capital gain exclusion, you must meet certain criteria. Let’s explore the factors that determine whether you are eligible for this exclusion and how you can minimize your tax liability.
Factors That Determine Eligibility for Capital Gains Tax Exclusion
If you sell a house and any of the following factors are true, you may not be eligible for the exclusion and may be liable to pay taxes on the whole gain of that sale:
1. The home wasn’t your principal residence
To be eligible for the exclusion, the home you’re selling must be your primary residence, meaning the place where you spend most of your time. The IRS defines “home” broadly, including condos, co-ops, mobile homes, and even houseboats.
If you own more than one home, you should conduct a “facts and circumstances” test to ensure that the home you’re selling will be recognized as a principal residence by the IRS.
Strengthening your home’s status as a primary residence includes using its address in your official documents (tax returns, driver’s license, voting registration, and with the Postal Service) and ensuring that it is close to your day-to-day needs, such as your bank, workplace, or organizations you are part of.
2. You owned the property for fewer than two years
The IRS requires that you have owned the home for at least two years in the five-year period before you sold it.
However, if you’re married and filing jointly, only one of the spouses is required to meet this test.
3. You didn’t live in the house for at least two years in the five-year period before you sold it
To establish that you intended to live in the house, the IRS requires you to have lived in it for at least two of the five years before the sale.
The 24 months don’t have to be consecutive, and temporary absences, such as vacations, don’t count as being “away.”
However, certain exceptions apply for disabled individuals, those needing outpatient care, and people in the military, Foreign Service, or intelligence community.
4. You already claimed the $250,000 or $500,000 exclusion
If you have already claimed the exclusion for another home in the two-year period before the sale of your current home, you cannot claim it again.
5. You bought the house through a like-kind exchange
If you purchased your home through a like-kind exchange, also known as a 1031 exchange, in the past five years, it may not qualify for the exclusion.
Like-kind exchanges involve swapping one investment property for another, and the IRS has specific rules regarding the exclusion for such properties.
6. You’re subject to expatriate tax
The expatriate tax is a fee levied by the IRS on certain individuals who have given up their U.S. citizenship or residency status as a result of living abroad for an extended period. If you fall into this category, you may not be eligible for the exclusion.
If you’re unsure whether you qualify for the exclusion, you can use online tools or consult with a tax professional to determine your eligibility. It’s essential to understand your tax obligations and explore strategies to minimize your capital gains tax liability.
How to Calculate Capital Gains Tax on a Home Sale
The capital gains tax on your home sale will depend on the profit you make from the sale. Profit is defined as the difference between the purchase price and the selling price of your home. Let’s consider an example to understand how to calculate capital gains tax.
Suppose you bought a home ten years ago for $200,000 and sold it today for $800,000. Your net profit would be $600,000.
If you’re married and filing jointly, you may be able to exclude up to $500,000 of that gain from the capital gains tax. However, the remaining $100,000 of the gain could be subject to taxation.
To determine the applicable capital gains tax rate, you need to consider whether the asset was owned for a short-term or long-term period:
- Short-term capital gains tax rates apply if you owned the asset for a year or less. The rate is equal to your ordinary income tax rate, which is determined by your income tax bracket.
- Long-term capital gains tax rates apply if you owned the asset for more than a year. The rates are generally lower, with some people qualifying for a 0% tax rate. Others may pay either 15% or 20%, depending on their filing status and income.
To find out which federal tax bracket you’re in, you can refer to the IRS’s federal income tax brackets guide.
How to Minimize Capital Gains Tax on Real Estate
Now that you understand how capital gains taxes work and the factors that determine your eligibility for the exclusion, let’s explore strategies to minimize your capital gains tax liability on real estate.
1. Live in the house for at least two years
To qualify for the exclusion, you must have lived in the house for at least two years. While the two years don’t need to be consecutive, it’s important to note that selling a house you didn’t live in for at least two years could make the gains taxable.
Selling within a year is especially expensive as it may subject you to the short-term capital gains tax, which is typically higher than the long-term capital gains tax.
2. See whether you qualify for an exception
Even if you have a taxable gain on the sale of your home, you might still be able to exclude some or all of it if you sold the house due to work, health reasons, or “an unforeseeable event,” as defined by the IRS.
To determine if you qualify for an exception, you can refer to IRS Publication 523 for detailed information.
3. Keep records of your home improvements
The cost basis of your home includes not just the purchase price but also the improvements you’ve made over the years.
It’s crucial to keep receipts and records of any home improvements, such as remodels, expansions, new windows, landscaping, fences, driveways, and air conditioning installations.
These improvements can increase your cost basis, potentially reducing your exposure to capital gains tax.
By utilizing these strategies and exploring other tax planning options, you can minimize your capital gains tax liability on the sale of your home.
It’s always advisable to consult with a tax professional to ensure you’re taking advantage of all available deductions and exemptions.
Selling a home can be a lucrative endeavor, but it’s important to consider the potential tax implications. Capital gains on real estate can be taxable, but by understanding the rules and utilizing strategies to minimize your tax liability, you can maximize your profits.
Remember to meet the eligibility criteria for the home sale capital gain exclusion, calculate your capital gains tax accurately, and explore options like exceptions and keeping records of home improvements.
By doing so, you can minimize the impact of capital gains tax on the sale of your home and make the most of your investment.