What Tax Do You Pay When Selling a Home?
Laura answers a listener question about how to cut taxes when selling a home. Find out what the capital gains tax is, how it’s figured, and six tips to legally sell your home tax free.
Laura Adams, MBA
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What Tax Do You Pay When Selling a Home?
Valerie H. says, “My mother has started thinking about selling her house and moving into a senior apartment. She purchased her California home over 20 years ago for $180,000 and now believes she could sell it for $550,000. Is there a legal way to cut the huge tax bill she would receive?”
(correction_with_script)
Valerie, this is a great question that affects everyone who sells a home and makes money on the deal. In this post I’ll explain the capital gains tax you pay when selling a home and 6 tips to legally sell your home tax free.
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What Is the Capital Gains Tax?
You already know that you have to pay tax on income from your job or interest from a bank savings account. Those are examples of ordinary income, which is taxed at some of the highest rates in the U.S.
But there’re another type of tax that you must pay when you make a net profit on an investment, such as stock or real estate. It’s called the capital gains tax—and, fortunately, it can be lower than the rate you have to pay on ordinary income. That’s the government’s way of encouraging you to be a long-term investor.
I’ll explain the basics of the capital gains tax and the special rules you should know that apply when you sell your main home.
Capital gains tax is triggered when you sell a capital asset for more than you paid for it. For instance, if you own stock or real estate that appreciates year after year, you don’t pay capital gains tax until you actually have a gain.
In other words, a profit that only exists on paper doesn’t cost you anything. The tax only kicks in when you sell the asset and bank the profit.
Let’s say you bought 500 shares of Apple stock in 2011 for $25,000 when the price was $50 a share. But now the stock is worth $100 a share, or $50,000, in 2016.
If you decide to sell all of your Apple stock, you’ll happily make a $25,000 ($50,000 selling price – $25,000 purchase price) profit—but also have to pay capital gains tax on that amount.
Also see: 6 Tips to Sell a House Fast in Any Market
What Is a Capital Loss?
It’s also important to understand that capital gains can be reduced or offset by capital losses, such as selling a stock for less than you paid for it. Losing money on an investment is never fun, but when it can cut your taxes, it reduces the sting a little.
Capital losses can be subtracted from capital gains. However, there are limits on the amount of loss you can declare. Only $3,000 (or $1,500 if you’re married and file taxes separately) of net capital losses can be deducted from your income in a given year.
But if you have net losses that total more than $3,000, you still get to capture them. You can roll over capital losses into future tax years until the entire amount has been deducted from your income.
However, selling your primary residence for a loss is an exception and this trips up a lot of people. You can’t deduct capital losses on real estate that is also your primary residence—only on investment property.
So if you lose money on the sale of your main home, it can’t be “written off” or deducted from your taxable income.
What is the Capital Gains Tax Exclusion When Selling a Home?
Even though a gain on any capital asset is taxable, you can generally avoid it by legally excluding all or a part of of your profit from tax.
But the downside of not being able to deduct losses on a residence is overshadowed by one of the biggest tax breaks you can get in the U.S., which is the capital gains tax exclusion on a home sale.
Even though a gain on any capital asset is taxable, you can generally avoid it by legally excluding all or a part of of your profit on a home sale from tax.
So how much gain can you make disappear? Well, it’s a pretty big chunk of change—up to $250,000 if you file as a single taxpayer. Or up to $500,000 if you’re married and file jointly.
Also, if you’re a widow or widower, who did not remarry before selling your home within 2 years, you can also typically exclude up to $500,000 of gain on the sale of your home. That’s huge!
Remember that it’s your gain, or profit, that is taxed. So you could sell your home for $5 million and avoid all tax as long as your profit from the deal is not more than $250,000 or $500,000, depending on your tax filing status.
Qualifications to Exclude Capital Gains Tax When Selling a Home
The requirements to be eligible for the capital gains tax exclusion on a home sale are pretty simple. You must have owned the home and used it as your main residence for periods that total at least 2 years out of the 5 years that precede the sale. This exclusion does not apply to investment property
The exclusion timing is extended to 2 of the previous 10 years if you or your spouse are eligible government employees, military, or work for the Peace Corps. And there are other circumstances that may allow you to qualify for a partial exclusion—such as having to move because of your work, health, or an unforeseeable event (like getting divorced or losing your job)—when you sell a home before staying there for 2 years.
Also see: 5 Ways to Save Money on Home Insurance
How Often Can You Exclude Capital Gains Tax When Selling a Home?
One of the best parts of the capital gains tax exclusion for home sales is that there’s no limit on the number of times you can take it in your lifetime. That’s an amazing tax benefit!
Since you typically have to live in a home for a minimum of 2 years to qualify, in theory you could sell a home tax free every 2 years if you were willing to sell, buy, and relocate that often.
One of the best parts of the capital gains tax exclusion for home sales is that there’s no limit on the number of times you can take it in your lifetime. That’s an amazing tax benefit!
You can only claim one primary residence at a time, even if you own multiple homes. And it can be any type of home, such as a single family house, condo, co-op, mobile home, or even a houseboat.
Remember that the capital gains tax exclusion doesn’t apply to investment property. However, if you own a rental property and decide to make it your primary residence before selling it, you’ll owe tax based on how long the home was used as a second home versus your main home.
See also: Best Mortgage Company to Shop Your Home Loan
How to Figure the Capital Gain When Selling a Home
You might be wondering how to calculate the gain on a home sale. It’s a little more complicated than simply subtracting your original purchase price from your selling price. And that’s a good thing because the details can work to your advantage.
For tax purposes, you have to figure your adjusted basis in the home. This is what you paid for it, plus any capital improvements that add value, and less any deductions you’ve taken.
Improvements—such as putting on a new roof, remodeling the kitchen, adding an extra bathroom, or installing a swimming pool—increase your adjusted basis, which decreases the amount of gain on a sale. But you can’t add minor repairs or maintenance, like painting or regular yard work, to your adjusted basis.
On the flip side, you have to reduce your adjusted basis by subtracting items that already reduced your taxes while you’ve owned the home. These might include depreciation, insurance losses, or tax credits. These work in the opposite way to increase your gain on a home sale.
For example, if you paid $200,000 for a home and then built a back porch that costs $5,000, your adjusted basis becomes $205,000. But then if a tree fell on the porch and you made a $3,000 tax-deductible claim, your adjusted basis would go down to $202,000.
Additionally, the costs to sell a home—such as real estate commissions, advertising, and title insurance—get deducted from your capital gain. So always keep meticulous records and receipts on every major financial transaction related to your home.
Also see: How to Buy a Home in 10 Steps
How Much Is the Capital Gains Tax?
What if you don’t qualify for the capital gains tax exclusion on a home sale? Any gain you make that exceeds the exclusion amount for your tax filing status is taxable.
Gains or losses must be reported on Form 8949opens PDF file and the final net number is entered on Form 1040, Schedule Dopens PDF file , Capital Gains and Losses.
How much tax you’ll owe depends on how long you’ve owned the home or investment and your tax bracket. An asset you’ve owned for a year to the day or less is considered short-term and one that you own for more than a year is long-term.
How much tax you’ll owe depends on how long you’ve owned the home or investment and your tax bracket.
These holding periods are important for a couple of reasons. First, capital gains and losses must mirror each other. You can only deduct short-term losses from short-term gains and long-term losses from long-term gains.
Another reason to understand the short and long distinction is because the tax on short-term gains is much higher than for long-term gains. Remember when I said that the government encourages long-term investing? This is how they incentivize you not to buy and sell investments too quickly.
The short-term capital gains tax rate matches the ordinary federal income tax rate, which ranges from 10% up to 39.6% for 2016.
But long-term capital gains are much lower and cap out at 20%. For 2016, the amount you pay depends on your federal income tax bracket:
- 10% to 15% tax bracket = long-term capital gains tax rate is 0%
- 25% to 35% tax bracket = long-term capital gains tax rate is 15%
- 39.6% tax bracket = long-term capital gains tax rate is 20%
So, let’s apply all this information to Valerie’s mother’s situation. We don’t know her adjusted basis in the home—but let’s assume that her gain would be $370,000, she’s a single taxpayer, and is in the 15% tax bracket.
Her exclusion would take $250,000 off the top, leaving $120,000 to be taxed at the long-term rate. If her federal income tax bracket is 15% or less, she wouldn’t owe any capital gains tax on the sale!
But if her federal tax rate is higher, she might owe 15% or 20%, costing $18,000 ($120,000 x 0.15) or as much as $24,000 ($120,000 x 0.20) in long-term capital gains.
And if she’s a widow who didn’t remarry in the 2 years preceding the sale, she could exclude up to $500,000 in gains, wiping out her entire $370,000 gain completely.
6 Tips to Understand the Capital Gains Tax Exclusion Rules
Here are 6 tips to sum up and help you understand the capital gains tax exclusion rules:
Tip #1: You must pass an ownership and use test
If you owned and lived in your home for at least 2 out of the 5 years prior to a home sale, you’re eligible to exclude a limited amount of gain on the sale from your income.
Tip #2: Exclusions apply only to main homes
If you own more than one home, you can exclude the gain on the sale of your main residence only. Your main home is the one you live in most of the time.
Tip #3: There is an exclusion limit
You can exclude up to $250,000 of a home sale gain from income or up to $500,000 if you’re married and file a joint tax return.
Tip #4: No reporting may be required
If your gain doesn’t exceed the exclusion amounts above, you don’t even need to report the home sale on your income tax return.
Tip #5: Gains above the exclusion are taxable
Any gain you make that exceeds the exclusion amount is taxable and must be reported on Form 1040, Schedule Dopens PDF file , Capital Gains and Losses.
Tip #6: Home losses are not deductible
If you sell your main home for a loss, it cannot be deducted from your taxable income.
There are worksheets in IRS Publication 523opens PDF file to help you figure capital gains on a home sale. But because it’s complicated and there’s so much money at stake, I recommend that you consult with a professional.
Be sure to reach out to a qualified tax accountant or tax attorney when you’re not sure if you qualify for the home gain exclusion or you aren’t sure how calculate the gain on your sale.
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About the Author
Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.