Capital gains are the profits you make on the sale of any asset. Such investments as securities, precious metals, and commodities ─ virtually anything you have made a profit are considered capital gains. In addition to federal capital gains tax, forty-two states also tax capital gains. (As a note, rates and rules differ for each state.)
Even if homeowners have gained tens of thousands of dollars in equity while owning their homes, most can avoid paying capital gains when they sell due to a special provision in the tax code known as the “homeownership exclusion.” In fact, the exclusion is one of the best tax breaks available to homeowners.
Under today’s tax rules, sellers who make a profit of less than $250,000 on the sale of their homes are exempt from paying capital gains taxes. On a joint tax return, a couple can make up to $500,000 the sale of their home tax-free.
Many homeowners qualify for the capital gains exclusion, but don’t know how to reduce or possibly avoid paying capital gains taxes by decreasing the size of their gain.
A deeper dive
Profits from a home you sell after owning it for less than a year are considered short-term capital gains. Short-term capital gains are taxed at the same rate as ordinary income, which will be higher than rates for long-term capital gains taxes.
Long-term capital gains taxes vary depending on your annual income. For example, if you earn $441,451 or more, your capital gains rate would be 20%. (See IRS tax year 2020 1040 tables.)
Conversely, if you lost money on any investment or asset, you can deduct your loss from the capital gains you earned on the sale of a home to reduce the net amount of capital gains taxes you will pay that year. (See IRS Topic 409 Capital Gains and Losses and IRS Publication 523 for more information on eligibility requirements and tax rates for different taxpayers.)
Qualifications for the homeownership capital gains exclusion
Home sellers can qualify for all or part of the capital gains tax exclusion by meeting a set of requirements, including:
- The exclusion applies only to homes used as primary residences for at least two of the five preceding years. Properties used solely for investment purposes or vacation homes do not qualify.
- You must own the home for a total of at least 24 months (2 years) of the five years preceding the sale date. The 24 months of residency can fall anywhere within the five years and need not be a single block of time. In some instances, such as a change in employment or a health issue, you may be eligible for a reduced exclusion.
- You made less than $250,000 on the house sale ($500,000 on a joint return), and you have not used the exclusion more than once in the past two years.
- A house traded for another using the 1030 Exchange Rule does not qualify for the exclusion.
See IRS Publication 523 for more details regarding exclusion criteria.
Calculating capital gains taxes on a home sale
Property sales price ─ property cost = No capital gains if less than $250,000 and meets the qualifications listed above ($500,000 for a joint return). See below for more information on the definition of property cost.
Short-term capital gains (owned less than 12 months) = Same rate as ordinary income
Long-term capital gains (owned 12 months or more) = Rates vary by filing status and income (see below)
Capital gains are based on the total cost of buying and caring for your home, not just the price you paid when you purchased it. You can significantly reduce the number of capital gains on selling a house by adding to your cost basis all the costs you incurred to buy it to maintain its value:
- Add to your cost basis (the amount you paid for the house you are selling) all closing and financing costs you paid when you purchased it. These include legal fees (including fees for the title search and preparing the sales contract and deed), recording and survey fees, inspection fees, appraisal, lenders’ fees, expenses, cost of a credit report, and taxes. Also include property taxes and homeowner’s insurance that you paid each year.
- Also, add to your cost basis what you have spent to maintain and improve your home’s value over the years you owned it. The longer you have lived in the house you sold, the more expenses you can add to your basis. These include upgrades such as room additions, new kitchens, and finished basements and maintenance such as new appliances, systems, landscaping, roofs, floors, and windows.
- Finally, include the costs of selling your home, including broker’s commission, staging, painting, landscaping, photography, and advertising.
Keep in mind that you cannot include temporary improvements that were not part of the home when you sold it, such as painting, fixing leaks, or cleaning. (See IRS Publication 523 for more information.)
Disciplined record keeping will save you money
You won’t know whether you will qualify for the $250,000 threshold for the paying capital gains exclusion or not until you sell it. Over the years, you may spend $100,000 or more in home improvements and upkeep — perhaps more than enough to lower your cost basis below the threshold so that you won’t pay a penny of capital gains tax when you sell.
The key to avoiding capital gains taxes is to keep good records. File away all your closing documents so that you will have records of your expenses. Every January, compile all your receipts, canceled checks, and bank statements from the previous year. Find all that will meet the test for costs that will help you lower your cost basis when you sell. When your cost basis is higher, your exposure to capital gains taxes is lower.
Even though you may not be planning to sell, keep current with the amount of equity you have in your home and whether or not you might be required to pay capital gain taxes when you retire. Use Homes.com’s valuation calculator for an estimate of what your home is worth. Use it to keep track of valuation trends over time for your home and comparable homes in your neighborhood. Keep track of your cost basis by calculating your maintenance and improvement expenses every year.