Before you sell a house, it’s helpful to understand how capital gains taxes work and whether you may qualify for a break.
If you recently sold or are getting ready to sell a house, you’re probably ready to move on and focus on your next home. But did you know that you may have to pay taxes on any profits earned on the sale of your last home?
The tax implications of selling a house may be minimal for some people, but not for others. You may have to pay capital gains taxes on any profits earned from the sale. Understanding how these rules work may help you minimize your overall tax bill. Remember to always consult a tax professional about the most current tax law and guidance.
- Do I have to report the sale of my home to the IRS?
- How do capital gains taxes work?
- How do I avoid capital gains tax on a property sale?
- Special circumstances to keep in mind
Do I have to report the sale of my home to the IRS?
If you’re selling a home that has significantly appreciated in value, you may be looking forward to a large payday. But depending on your situation, you could end up owing the IRS money for any profits earned on the home sale.
That’s because your home is an asset and is subject to capital gains taxes. But the IRS provides exceptions to this rule, which many sellers may qualify for.
For instance, if you’re married and filing jointly, in tax year 2021 you may be able to exclude up to $500,000 from the sale of your home. Typically, you’ll be eligible for this exclusion if the home is your primary residence, and you’ve owned and lived in it at least two of the last five years when filing 2021 taxes.
Just remember to check with a tax professional to learn what the current year’s IRS rules are before you file your taxes.
How do capital gains taxes work?
A capital gains tax is a tax placed on any profits earned when a capital asset is sold. The IRS considers almost everything you own and use for personal or investment purposes to be a capital asset. These taxes are due on the tax deadline after the asset is sold, and it applies investments like stocks, bonds and real estate.
And the IRS classifies capital asset gains into one of two categories: short-term and long-term gains. Generally, if you’ve lived in your home for less than a year, it’s a short-term gain. If you’ve lived in the home for a year or more, it’s considered a long-term gain.
So when you sell your home, the capital gains tax depends primarily on how long you’ve owned the home and your income.
If you have a short-term gain, you’ll be taxed at whatever your normal tax bracket is. A long-term capital gain gets preferential tax treatment and is taxed at a rate of 0%, 15%, 20% or 28%. These rates vary according to your income and tax filing status.
According to the IRS, “most individuals” won’t pay more than 15% on capital gains taxes. If your net income is less than $80,000, your net capital gain may be taxed at 0%, according to IRS.gov.
And if you meet certain conditions, you can exclude the first $250,000 to $500,000 from the sale of your home and avoid paying taxes on it altogether.
How do I avoid capital gains tax on a property sale?
Whenever you sell a house, it can be subject to capital gains taxes. But fortunately, the IRS provides certain exclusions that some home-sellers qualify for.
If you meet certain requirements, you can exclude $250,000 from the sale of your home. That number increases to $500,000 if you’re married and filing jointly.
For instance, let’s say you’re married and you and your spouse bought a home 10 years ago for $300,000 — and the value of homes in your neighborhood has significantly increased since that time. When you go to sell the home, you receive an offer for $700,000.
Under the exclusion, you won’t have to pay any capital gains taxes on the sale. But to qualify for exemption, you must meet the following three criteria:
- You’ve owned the home for at least two years during the past five years prior to the sale (this doesn’t have to be continuous). If you’re married and filing jointly, only one spouse needs to meet this requirement.
- You used the home as your principal residence for at least two of the five years prior to the sale. Unlike above, if you’re married and filing jointly, both spouses need to meet this requirement.
- You haven’t sold another home during the two years before the sale, or — if you did — you didn’t take the exclusion of gain earned from it.
Special circumstances to keep in mind
If you don’t meet the IRS’ eligibility requirements, you may still be able to claim a full or partial exception under the following situations:
- You gained ownership of the home during a separation or divorce.
- Your spouse died during the period when you retained ownership of the home.
- The sale of the home involves vacant land.
- You owned what the IRS calls a “remainder interest” in the home and sold it.
- Your previous home was destroyed.
- Your previous home was condemned.
- You were a service member while you owned the home.
- You gave or released the home in what the IRS calls a “like-kind” exchange.
If you recently sold a home and are wondering whether you’ll have to pay capital gains taxes, the first step is to determine the profit earned from the sale. To do this, you need to determine the cost basis for the home.
The cost basis is the money you spent to buy the home, and any money you’ve spent on home improvements over the years. For instance, if you purchased a home for $300,000 and spent $50,000 on home improvements, your cost basis is $350,000.
From there, you can add up the purchase price of the home, minus certain fees you paid for things like closing costs and the services of a real estate agent. Then you can subtract your cost basis from any money you earned from the sale.
But capital gains taxes can be complex, and there are gray areas. If you’re not sure whether you qualify for the capital gains exemption, it’s a good idea to consult with a financial adviser or tax specialist who can walk you through the details.