By CHAD LANGAGER
Mar 30, 2021
Your home is likely your life's biggest and proudest purchase. All the painstaking measures you took—countless property searches, contract negotiations, inspections, and closing—to arrive at the dream of homeownership. Now, it's time to sell. What next? Did you know that your home is considered a capital asset, subject to capital gains tax? If your home appreciated in value, you could be required to pay taxes on the profit. However, thanks to the Taxpayer Relief Act of 1997, most homeowners are exempt.
If you are single, you will pay no capital gains tax on the first $250,000 of profit (excess over cost basis). Married couples enjoy a $500,000 exemption. There are, however, some restrictions.
You can sell your primary residence and be exempt from capital gains taxes on the first $250,000 if you are single and $500,000 if married filing jointly.
This exemption is only allowable once every two years.
You can add your cost basis and costs of any improvements you made to the home to the $250,000 if single or $500,000 if married.
How Much Is Capital Gains Tax on Real Estate?
To be exempt, the home must be considered a primary residency based on Internal Revenue Service (IRS) rules. These rules state that you must have occupied the residence for at least two of the last five years.
If you buy a home and a dramatic rise in value causes you to sell it a year later, you would be required to pay capital gains tax. If you've owned your home for at least two years and meet the primary residence rules, you may owe tax on the profit if it exceeds IRS thresholds. Single persons can exclude up to $250,000 of the gain, and married persons filing a joint return can exclude up to $500,000 of the gain.
This rule even allows you to convert a rental property into a primary residence because the two-year residency requirement does not need to be fulfilled in consecutive years.1
Suppose you purchase a new condo for $300,000. You live in it for the first year, rent the home for the next three years, and when the tenants move out, you move in for another year. After five years, you sell the condo for $450,000. No capital gains tax is due because the profit ($450,000 - $300,000 = $150,000) does not exceed exclusion amount. Consider an alternative ending in which home values in your area increased exponentially.
In this scenario, you sell the condo for $600,000. Capital gains tax is due on $50,000 ($300,000 profit - $250,000 IRS exclusion). If your income falls between $80,000 and $441,450, your capital gains tax rate as a single person is 15%.3 If you have capital losses elsewhere, you can offset the capital gains from the sale of the house by those losses, and up to $3,000 of those losses from other taxable income.
The other major restriction is that you can only benefit from this exemption once every two years. Therefore, if you have two homes and lived in both for at least two of the last five years, you won't be able to sell both of them tax-free.
The Taxpayer Relief Act of 1997 has been beneficial for homeowners because it has significantly changed the implications of home sales. Before the act, sellers had to roll the full value of a home sale into another home within two years to avoid paying capital gains tax. This, however, is no longer the case, and the proceeds of the sale can be used in any way the seller sees fit.
If you meet the eligibility requirements of the IRS, you'll be able to sell the home capital gains tax-free as stated above. However, there are exceptions to the eligibility requirements, which are outlined on the IRS website.
When Is a Home Sale Fully Taxable?
Not everyone can take advantage of the capital gains exclusions. Gains from a home sale are fully taxable when:
The home is not the seller's principal residence
The property was acquired through a 1031 exchange within five years
The seller is subject to expatriate taxes
The property was not owned and used as the seller's principal residence for at least two of the last five years prior to the sale (some exceptions apply)
The seller sold another home within two years from the date of the sale and used the capital gains exclusion for that sale5
Capital Gains Tax on Home Sale Example
Consider the following example. Susan and Robert, a married couple, purchased a home for $500,000 in 2015. Their neighborhood experienced tremendous growth and home values increased significantly. Seeing an opportunity to reap the rewards of this surge in home prices, they sold their home in 2020 for $1.2 million. The capital gains from the sale were $700,000.
As a married couple filing jointly, they were able to exclude $500,000 of the capital gains, leaving $200,000 subject to capital gains tax. Their combined income places them in the 20% tax bracket. Therefore, their capital gains tax was $40,000.
How to Avoid Capital Gains Tax on Home Sales
Want to lower the tax bill on the sale of your home? There are ways to reduce what you owe or avoid taxes on the sale of your property. If you own and have lived in your home for two of the last five years, you can exclude up to $250,000 ($500,000 for married people filing jointly) of the gain from taxes.
Adjustments to the cost basis can also help reduce the gain. Your cost basis can be increased by including fees and expenses associated with the purchase of the home, home improvements, and additions. The resulting increase in the cost basis thereby reduces the capital gains.
Also, capital losses from other investments can be used to offset the capital gains from the sale of your home. Large losses can even be carried forward to subsequent tax years. Let's explore other ways to reduce or avoid capital gains taxes on home sales.
Use 1031 Exchanges to Avoid Taxes
Homeowners can avoid paying taxes on the sale of their home by reinvesting the proceeds from the sale into a similar property through a 1031 exchange. This like-for-like exchange—named after the IRS code Section 1031—allows for the exchange of like property with no other consideration or like property including other considerations, such as cash. The 1031 exchange allows for the tax on the gain from the sale of a property to be deferred, rather than eliminated.
Owners—including corporations, individuals, trust, partnerships, and LLCs—of investment and business properties can take advantage of the 1031 exchange when exchanging business or investment properties for those of like kind.6
The properties subject to the 1031 exchange must be for business or investment purposes, not for personal use. The party to the 1031 exchange must identify in writing replacement properties within 45 days from the sale and must complete the exchange for a property comparable to that in the notice within 180 days from the sale.
Since executing a 1031 exchange can be a complex process, there are advantages to working with a reputable, full-service 1031 exchange company. Given their scale, these services generally cost less than attorneys who charge by the hour. A firm that has an established track record in working with these transactions can help you avoid costly missteps and ensure that your 1031 exchange meets the requirements of the tax code.
Convert Your Second Home into Your Primary Residence
Capital gains exclusions are attractive to many homeowners, so much so that they may try to maximize its use throughout their lifetime. Because gains on non-primary residences and rental properties do not have the same exclusions, more people have sought clever ways to reduce their capital gains tax on the sale of their properties. One way to accomplish this is to convert a second home or rental property to a primary residence.
A homeowner can make their second home as their primary residence for two years before selling and take advantage of the IRS capital gains tax exclusion. However, stipulations apply. Deductions for depreciation on gains earned prior to May 6, 1997, will not be considered in the exclusion.
According to the Housing Assistance Tax Act of 2008, a rental property converted to a primary residence can only have the capital gains exclusion during the term in which the property was used as a principal residence.7 The capital gains are allocated to the entire period of ownership. While serving as a rental property, the allocated portion falls under nonqualifying use and is not eligible for the exclusion.
To prevent someone from taking advantage of the 1031 exchange and capital gains exclusion, the American Jobs Creation Act of 2004 stipulates that the exclusion applies if the exchanged property had been held for at least five years after the exchange.
How Installment Sales Lower Taxes
Realizing a large profit at the sale of an investment is the dream. However, the corresponding tax on the sale may not be. For owners of rental properties and second homes, there is a way to reduce the tax impact. To reduce taxable income, the property owner might choose an installment sale option, in which part of the gain is deferred over time. A specific payment is generated over the term specified in the contract.
Each payment consists of principal, gain, and interest, with the principal representing the non-taxable cost basis and interest taxed as ordinary income. The fractional portion of the gain will result in a lower tax than the tax on a lump-sum return of gain. How long the property owner held the property will determine how it's taxed: long-term or short-term capital gains.
How Real Estate Taxes Work
Like most purchases we make, taxes are assessed on the purchase price. The same is true for real estate. State and local governments levy real estate or property taxes on real properties; these collected taxes help pay for public services, projects, schools, and more.
Real estate taxes are ad-valorem taxes, which are taxes assessed against the value of the home and the land it sits on. It is not assessed on the cost basis — what was paid for it. The real estate tax is calculated by multiplying the tax rate by the assessed value of the property. Tax rates vary across jurisdictions and can change, as can the assessed value of the property. However, some exemptions and deductions are available for certain situations.
How to Calculate Cost Basis of a Home
The cost basis of a home is what you paid (your cost) for it. Included is the purchase price, certain expenses associated with the home purchase, improvement costs, certain legal fees, and more.
Example: In 2010, Rachel purchased her home for $400,000. She made no improvements and incurred no losses for the ten years she lived there. In 2020, she sold her home for $550,000. Her cost basis was $400,000, and her taxable gain was $150,000. She elected to exclude the capital gains and, as a result, owed no taxes.
What Is Adjusted Home Basis
The cost basis of a home can change. Reductions in cost basis occur when you receive a return of your cost. For example, you purchased a house for $250,000 and later experienced a loss from a fire. Your home insurer issues a payment of $100,000, reducing your cost basis to $150,000 ($250,000 original cost basis - $100,000 insurance payment).
Likewise, some events and activities can increase the cost basis. For example, you spend $15,000 to add a bathroom to your home. Your new cost basis will increase by the amount you spent to improve your home.
Basis When Inheriting a Home
If you inherited a house, the cost basis is the fair market value (FMV) of the home when the original owner died.9 For example, you inherit a home that the original owner paid $50,000 for. The home was valued at $400,000 at the time of the original owner's death. Six months later, you sell the home for $500,000. The taxable gain is $100,000 ($500,000 sales price - $400,000 cost basis).
The fair market value is determined on the date of the death of the grantor or on the alternate valuation date if the executor files an estate tax return and elects that method.10
Reporting Home Sale Proceeds to the IRS
It is required to report the sale of a home if you received a Form 1099-S reporting the proceeds from the sale or if there is a non-excludable gain. Form 1099-S is an IRS tax form reporting the sale or exchange of real estate. This form is usually issued by the real estate agency, closing company, or mortgagee. If you meet the IRS qualifications for not paying capital gains tax on the sale, inform your real estate professional by Feb. 15 following the year of the transaction.11
The IRS details what transactions are not reportable:
If the sales price is $250,000 ($500,000 for married persons) or less and the gain is fully excludable from gross income. The homeowner must also affirm that they meet the principal residence requirement. The real estate professional must receive certification that these attestations are true.
If the transferor is a corporation, a government or government sector, or an exempt volume transferor (someone who has or will sell 25 or more reportable real estate properties to 25 or more parties)
Non-sales, such as gifts
A transaction to satisfy a collateralized loan
If the total consideration for the transaction is $600 or less, which is called a de minimus transfer12
What happens in the event of a divorce or for military personnel? Fortunately, there are considerations for these situations. In a divorce, the spouse granted ownership of a home can count the years the home was owned by the former spouse to qualify for the use requirement.13 Also, if the grantee has ownership in the house, the use requirement can include the time the former spouse spends living in the home until the date of sale.
Military personnel and certain government officials on official extended duty and their spouses can choose to defer the five-year requirement for up to ten years while on duty. Essentially, as long as the military member occupies the home for 2 out of 15 years, they qualify for the capital gains exclusion (up to $250,000 for single taxpayers and up to $500,000 for married taxpayers filing jointly).
Capital Gains Taxes on Investment Property
Real estate can be categorized differently. Most commonly, it is categorized as investment or rental property or principal residences. An owner's principal residence is the real estate used as the primary location in which they live. An investment or rental property is real estate purchased or repurposed to generate income or a profit to the owner(s) or investor(s).
How the property is classified affects how it's taxed and what tax deductions, such as mortgage interest deductions, can be claimed. Under the Tax Cuts and Jobs Act of 2017, up to $750,000 of mortgage interest on a principal residence can be deducted. However, if a property is solely used as an investment property, it does not qualify for the capital gains exclusion.
Deferrals of capital gains tax are allowed for investment properties under the 1031 exchange if the proceeds from the sale are used to purchase a like-kind investment. And capital losses incurred in the tax year can be used to offset capital gains from the sale of investment properties. So, although not afforded the capital gains exclusion, there are ways to reduce or eliminate taxes on capital gains for investment properties.
Rental Property vs. Vacation Home
Rental properties are real estate rented to others to generate income or profits. A vacation home is real estate used recreationally and not considered the principal residence. It is used for short-term stays, primarily for vacations.
Often, homeowners convert their vacation homes to rental properties when not in use by them. The income generated from the rental can cover the mortgage and other maintenance expenses. There are a few things to keep in mind, however. If the vacation home is rented out for less than 15 days, the income is not reportable. If the vacation home is used by the homeowner for less than two weeks in a year and then rented out for the remainder, it is considered an investment property.
Homeowners can take advantage of the capital gains tax exclusion when selling their vacation home if they meet the IRS ownership and use rules.
Real Estate Taxes vs. Property Taxes
Real estate and property are often used interchangeably, as are real estate taxes and property taxes. However, property is a broad term to describe different assets, including real estate, owned by a person; and not all property is taxed the same.
Property taxes, as it relates to real estate, are ad-valorem taxes assessed by the state and local governments where the real property is located. The real estate property tax is calculated by multiplying the property tax rate by real property's market value, which includes the value of the real property (e.g., houses, condos, and buildings) and the land it sits on.
Property taxes, as it relates to personal property, are taxes applied to movable property. Real estate, which is immovable, is not included in personal property tax. Examples of personal property include cars, watercraft, and heavy equipment. Property taxes are applied at the state or local level and may vary state-to-state.
Capital Gains Tax on Real Estate FAQs
Are Home Sales Tax-Free?
Home sales are tax-free if the condition of the sale meets certain criteria. The seller must have owned the home and used it as their principal residence for two out of the last five years (up to the date of closing). The two years must not be consecutive to qualify. The seller must not have sold a home in the last two years and claimed the capital gains tax exclusion. If the gains do not exceed the exclusion threshold ($250,000 for single people and $500,000 for married people filing jointly), the seller does not owe taxes on the sale of their house.
How Do I Avoid Paying Taxes When I Sell My House?
There are several ways to avoid paying taxes on the sale of your house. Here, we'll list a few:
Offset your capital gains with capital losses. Capital losses from previous years can be carried forward to offset gains in future years.
Consider using the IRS primary residence exclusion. For single taxpayers, you may exclude up to $250,000 of the capital gains, and for married taxpayers filing jointly, you may exclude up to $500,000 of the capital gains (certain restrictions apply).
Also, under a 1031 exchange, you can roll the proceeds from the sale of a rental or investment property into a like investment within 180 days.
How Much Taxes Do I Pay When Selling My House?
How much taxes you pay is dependent on the amount of the gain from selling your house and your tax bracket. If your profits do not exceed the exclusion amount and you meet the IRS guidelines for claiming the exclusion, you owe nothing. If your profits exceed the exclusion amount and you earn less than $80,000 per year, you will owe a 15% tax (based on the single filing status) on the profits.14
The tax rate is dependent on income. It is important to consult a tax professional to determine and discuss your tax obligation.
Do I Have to Report the Sale of My Home to the IRS?
It is possible that you are not required to report the sale of your home if none of the following are true:
You have non-excludable, taxable gain from the sale of your home (>$250,000 for single taxpayers and >$500,000 for married taxpayers filing jointly).
You were issued a 1099-S, reporting proceeds from real estate transactions.
You want to report the gain as taxable, even if all or a portion falls within the exclusionary guidelines.15
The Bottom Line
Taxes on capital gains can be substantial. Fortunately, the Tax Relief Act of 1997 provides some relief to homeowners who meet certain IRS criteria. For single tax filers, up to $250,000 of the capital gains can be excluded, and for married tax filers filing jointly, up to $500,000 of the capital gains can be excluded. For gains exceeding these thresholds, capital gains rates are applied.
There are exceptions for certain situations, such as divorce and military deployment, and there are rules for when sales must be reported. Understanding the tax rules and staying abreast of tax changes can help you better prepare for the sale of your home.
If you're thinking about selling your home, contact me today for a free Comparative Market Analysis.
Amy Booth, REALTOR
Elite Real Estate Professionals