A net gain on a home sale of $680k potentially could lead to having to pay capital gains taxes. But in many cases, you won't have to pay taxes on the full amount of the gain. And you may be able to shield all of it. This is due to an exclusion that protects from taxation up to $500,000 in gains when you sell your primary residence. The exact amount you can exclude will vary depending on the circumstances. And there are moves you may be able to make to reduce, delay or even eliminate taxes on a home sale. Capital gains taxes are sensitive to your specific situation, so consider consulting with a financial advisor about your course of action.
Capital Gains on Home Sales
Any time you sell an asset for more than you paid, you generate a capital gain. The IRS considers this gain to be taxable. That applies to a gain on sale of any asset, including securities and investment real estate. However, due to the Section 121 Exclusion – named after a section of the tax code – when selling a personal residence up to $500,000 of the gain may be excluded from taxation.
How much you will be able to shield from taxes may vary. To begin with, the $500,000 exemption is only available for taxpayers who are married and file tax returns jointly. If you're an individual filing singly, you can exclude only up to $250,000 of your gain.
You may not be able to get any exclusion at all, if you have not lived in the home for at least two of the preceding five years. The years don't have to be consecutive, but the time you've occupied the home must total at least two full years out of the previous five.
If you lived in the home for a shorter period, the entire gain would be taxable. And it's only for a principal residence. Vacation homes, second homes and investment property don't qualify.
Also, it must be at least two years since the last time you claimed the 121 exclusion. You can do it as many times as you want up to your lifetime exclusion limit, but not more often than every two years. Before 1997 there was a one-time lifetime exclusion of up to $125,000 for homeowners aged 55 or older. The Taxpayer Relief Act of 1997 made a number of changes, including scrapping the one-time lifetime exclusion and age requirement.
A financial advisor can help you stay on top of changes to tax law and strategize accordingly.
Capital Gains Tax Rates
The specific tax you may owe can also vary. A gain by a seller who has owned the home for less than a year is considered a short-term capital gain. This is treated like ordinary income with the tax using regular federal income tax brackets that go up to a top marginal rate of 37%.
If the seller has owned the home for at least one year, on the other hand, long-term capital gains tax rates apply. These are generally lower than ordinary income rates, going from zero to a maximum of 20%.
A Capital Gains Example
A married couple who netted $680,000 from selling their principal residence after living in the home at least two of the preceding five years usually would be able to exclude $500,000 the gain, assuming they have not used the Section 121 exclusion before. This means $180,000 could be subject to taxes.
If they had a combined income of $100,000, they would normally be in the 22% marginal federal income tax bracket and owe federal income taxes of $14,261. After selling their home, the $180,000 of non-excluded gain on their home sale would be subject to capital gains taxes.
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The applicable capital gains tax rate can vary. It depends on whether the seller has owned the home for at least one year before the sale and also on the seller's income tax bracket. A seller who has not owned the home for at least one year normally would have any gain taxed as ordinary income, in this case at the 22% income tax rate.
For a sale where the home was owned for more than one year, the preferred capital gains rates of 0%, 15% or 20% would apply, instead of regular income tax rates. Your capital gains tax rate is also dependent on your income.
This married couple of with income of $100,000 and a taxable gain of $180,000 after the $500,000 exclusion would pay taxes on the gain at a rate of 15%. This would mean capital gains taxes of $180,000 times 15% or approximately $27,000.
A financial advisor can help you determine whether you'll owe taxes on your home sale depending on your specific circumstances. Get matched with a financial advisor.
Other Strategies
If it looks like you might owe capital gains taxes on part of the sale of your home, you may be able to adjust the home's cost basis by deducting the cost of some improvements from the sale price. This reduces the amount of the gain and the resulting tax. For instance, if you had spent $20,000 to replace a roof and $40,000 to add a bathroom, you might be able to increase the cost basis by $60,000 and reduce the taxable gain by a similar amount.
Another method to consider is a like-kind exchange, or a 1031 exchange, after another tax code section. To do this, you essentially trade one investment property for a lower-priced one. Done correctly, you won't owe any taxes on the difference in the prices of the two properties until you sell the lower-priced one.
Like-kind exchanges can't be done with a principal residence, however. It's only for investment property. To meet the restrictions, you would have to convert your home into an investment property by renting it for at least two years before the sale. Then you would have to rent out the home being purchased a similar period after the sale. Only then could it be used as the retiree's principal residence.
Tax-loss harvesting may also be helpful to reduce your tax bill. This works by applying a loss on the sale of another asset to reduce the capital gain on the sale of your home. Say you sold stocks for a loss of $60,000. By applying this loss on a stock transaction to the gain on your home sale, you could reduce the capital gain on the home transaction. Specific rules apply, so it may be prudent to speak with a fiduciary financial advisor about your strategy.
Bottom Line
You can often shield from taxes all or part of the gain when selling a home. To use this, you have lived in the home for two years before the sale. You can $250,000 if you are a single filer and $500,000 if you file jointly. If your gain is more than that, or if you can't exclude any at all, the tax will depend on how long you owned the home. The gain is likely to be taxed as ordinary income if you owned it for less than a year. For a home owned longer, the lower long-term capital gains rate is used.
Tips
A financial advisor can help you figure your likely tax liability when selling your home. Finding a financial advisor doesn't have to be hard. SmartAsset's free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now.
Use SmartAsset's Capital Gains Tax Calculator to estimate capital gains taxes when you're selling a home, investment real estate or any other asset.
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