Capital Gains Tax: When Selling Your Home for a Profit Can Hurt
When you buy real estate, especially your own home, your primary concern probably isn’t what price you will get for it when you sell it. But when you do get around to selling that real estate, you certainly don’t want to sell it for less than you paid. Making a profit is great, but be mindful of the risk of incurring capital gains tax.
What are “Capital Gains?”
Capital gains are the difference between the purchase price of an asset and the selling price when you sell it down the road. What you pay is called your “basis” in the asset and includes any improvements made to the asset. For instance, if you buy a house for $200,000 and make $50,000 worth of improvements to the house, your basis in the house is $250,000. If you later sell the house for $400,000, your capital gains are $150,000.
Real estate isn’t the only kind of asset that can be subject to capital gains tax: stocks, bonds, artwork, vehicles and boats are only some of the types of capital assets on which gains can be realized.
What is Capital Gains Tax?
In certain situations, the Internal Revenue Service (IRS) taxes capital gains. You may have sold a house for a profit in the past but don’t remember paying capital gains tax. You may not have. That is because the federal government excludes $250,000 of capital gains on real estate for an individual taxpayer, and $500,000 for a married couple filing jointly. In our example above, the capital gains were $150,000, so you would not have owed capital gains tax.
However, there are some circumstances in which those exclusions from capital gains tax don’t apply. Let’s talk about what they are and what you can still do to avoid, or at least minimize, capital gains taxes on the sale of real estate.
When You’re at Risk of Capital Gains Tax
Most homeowners don’t stay in the same home for their entire lives. The $250,000/$500,000 exclusions from capital gains tax allows people to buy a family home, and then sell it when the need arises and buy a different one without facing taxes on selling a house.
However, there are some situations in which sellers can’t claim those exclusions. It’s important to understand what those are so you can learn how to avoid paying capital gains tax on real estate.
The capital gains tax exclusion does not apply to a sale of real estate if:
- The property you sold was not your principal residence (like a vacation home or investment property). According to the IRS, a condominium, mobile home, or even a houseboat can qualify as a “principal residence” if it meets certain criteria.
- You owned the real estate that you sold for less than two years in the five-year period just prior to the sale;
- You did not live in the house for at least two years during the five-year period just prior to the sale. However, there may be exceptions for military service members, members of the foreign service or intelligence communities, or individuals with disabilities;
- You are subject to expatriate tax (like a U.S. resident who has renounced their citizenship);
- You acquired the property through a like-kind exchange, also referred to as a 1031 exchange, within the past five years;
- In the two-year period prior to the sale of the home, you previously claimed the exclusion on the sale of another home.
If any of the above circumstances apply to you (or if your gain exceeds your exclusion amount), you will probably have to pay capital gains tax on your real estate sale. Then the question becomes: how much? The amount of capital gains tax on a home sale will depend in large part on whether it is a short-term or long-term gain.
Short-term capital gains tax will apply if you owned the real estate for less than one year, such as an investment property that you “flipped.” The short-term capital gains tax rate is the same rate on which you are taxed for ordinary income.
If you owned the real estate for over a year, you will probably qualify for the long-term capital gains tax rate, which is much more favorable. The maximum is 20%, but many people pay much less than that.
How to Avoid Capital Gains Tax on Real Estate
There are a number of actions you may be able to take to minimize your exposure to capital gains tax or avoid it altogether. For instance, if you are able to do so, live in a house for at least two years out of five before selling it. While it’s typical for that time to be consecutive, it doesn’t need to be, just so it totals at least two years within the five-year period. (If you want to take the $500,000 exclusion for a married couple filing jointly, both spouses must have lived in the house for two years). Some periods of absence from the home, such as vacations, may still count toward the two-year requirement. If you can’t manage to live in a house for two years, try to hold on to the house for at least one year before selling it so that you won’t have to pay the more burdensome short-term capital gains tax.
You must meet both the two-year ownership and residence tests to qualify for the exclusion from capital gains taxes, but there are some exceptions. For instance, if the home was transferred to you by a spouse or ex-spouse, in a divorce or otherwise, you can count their ownership time toward the ownership requirement. However, you must meet the residence requirement on your own. If you are widowed and have not owned and lived in the house for the required two years, you can count any time that your late spouse owned and lived in the house without you toward the ownership and residence requirements. However, you must not be remarried as of the time you sell the house.
If you do have a taxable gain on the sale of your home, you may still be able to exclude some of the gain if the sale was due to certain circumstances. Consult an experienced tax professional to see if you qualify.
Lastly, remember that your basis in the home is not just the price you paid for it; it includes the cost of improvements. If you have updated a kitchen or bathroom, replaced a roof, or added a deck, you might be able to add tens of thousands of dollars to your basis, reducing the amount of taxable gains.
The Bottom Line
Selling real estate carries the opportunity for financial gain, but you need to be proactive to make sure the IRS doesn’t come calling for a cut of your profit. Schedule an appointment today with the accounting and tax preparation professionals at Gudorf Tax Group.