Selling a house is one of the biggest steps in a person’s life, one that not everyone will experience. The process comes with the potential joy of making a sum of money, along with the thrill of moving into a new home elsewhere.
While selling a home is extremely exciting, the process is a bit more complicated than you might think. Something that home sellers don’t often think about is taxes on their sold properties, particularly capital gains taxes. This is why many sellers opt to hire an experienced REALTOR®. Learn more about what taxes do you pay when selling a house and how you can minimize or even avoid those taxes.
Understanding capital gains taxes
You get taxed for any money you make, and that includes profits on a sold home. Capital gain refers to any profits that come from the sale of an asset, including stock shares, a business, a piece of land, and a home sale. Essentially, if you sell your home for more than your initial purchase price, you made a capital gain.
Income from capital gains is taxed at a specific rate based on your taxable income and your filing status (single, married, etc.). In 2020, for example, capital gains tax rates were 0 percent, 15 percent, and 20 percent on assets held for over a year.
Capital gains tax exclusion
The good news about home sales: most homeowners who sell their homes are granted a capital gains tax exemption thanks to the Taxpayer Relief Act of 1997. In fact, the large majority of people who sell their homes don’t even have to report a home sale transaction to the IRS, though much of this also depends on how long you have lived in the home and the actual profits made.
To be included in this tax exemption, the home that you sold must be considered a primary residency. Under the rules of the IRS, a home is considered your primary residence for at least two out of the last five years.
This can even apply to rental property as the two years do not have to be consecutive. For example, you may have a home that you lived in for the first year before converting it to a rental property for the next three years. At the end of the three years, the tenants move out, and you move back in for another year. That makes the property a primary residency.
Profit made on sale
In terms of profit, the IRS allows you to exclude up to $250,000 of your profit on the sale if you are single. If you are married and filing a joint return, that exclusion amount goes up to $500,000. For example, if you are single and made a profit of just $200,000 on your home sale, you wouldn’t have to pay any taxes on that amount.
On the other hand, if you made $600,000 on a home sale and file jointly with your spouse, the tax exclusion would apply to $500,000 of that amount. This means that you would have to still pay taxes on the leftover $100,000.
You can apply this exclusion to essentially every home sale. However, you cannot apply this exclusion on home sale gains within two years prior of the sale. For example, if you sold a home one year ago and applied the exclusion, you would not be able to apply the exclusion to a home sale this year.
Disqualifications for the exclusion
The above tax exclusion generally applies to everyone. However, there are some situations when the exclusion does not apply, requiring you to pay taxes on all of your gains.
- The house was not your primary residence.
- You owned the property for less than two years in the last five years.
- You did not reside in the property for two of the last five years.
- You already claimed the exclusion on another home in the last two years.
- You are subject to expatriate taxes.
- You bought the property through a like-kind exchange in the last five years. A like-kind exchange, also known as a 1031 exchange, basically involves swapping one investment property for another investment property of similar value.
However, even within these disqualifying factors, you can find some room to make an exclusion. For example, even if you have not lived in the property for two of the last five years, the IRS will make exceptions for those with disabilities and those who are serving in the military, Foreign Service, or the intelligence community.
Even if you do not meet the requirements, there are special circumstances when you may still qualify for the tax exclusion or even a partial exclusion.
- You may include short temporary absences as time lived in the house to meet the home use requirement. This applies even if you rented the home during these short absences.
- If you get the home as part of a divorce settlement, you can count the time that your former spouse owned the home toward the home use time.
- If you are granted use of the home as part of a divorce settlement, the former spouse who does not live in the home can actually count the days that the other spouse does live in the home.
- In the event of a spouse’s passing, if the surviving spouse has not remarried by the time the house has been sold, they may count the deceased spouse’s ownership and usage of the property toward their own use requirements.
Even if you do not pass the two-out-of-five-year requirement, you may still be eligible for a reduced exclusion. A reduced exclusion simply means that you get less than the regular $250,000 or $500,000 exclusion.
Reduced exclusions are available to those who are forced to sell their homes prior to living in the property for two out of five years. The circumstances may include:
- A change of health
- A change of employment
- Unforeseen circumstances, like a divorce or multiple births from a single pregnancy
This means that, if you have to move because you suddenly gave birth to twins, the IRS would not penalize you for it.
Paying capital gains taxes
If you are completely ineligible for the exclusion, you will have to pay taxes on all or part of the sale of your home. Start by figuring out your capital gains tax rate. If you owned the property for less than a year, you can look at short-term capital gains tax rates. This rate is the same as your ordinary tax rate (i.e., your tax bracket).
If you owned the property for longer than one year, you will have to pay long-term capital gains tax rates. These rates depend on your filing status and income. Many people actually qualify for a 0 percent tax rate, while everyone else pays 15 to 20 percent.
Minimizing or avoiding capital gains taxes
If you are not eligible for the full capital gains tax exclusion, you can take some steps to avoid or reduce the amount that you pay in property tax.
Use a 1031 exchange
As mentioned above, a 1031 exchange (also known as a like-kind or like-for-like exchange) can help you to avoid paying taxes on a home sale. By reinvesting the proceeds of a sale into a similar property, you can actually defer taxes on those gains. Just remember that deferring taxes is not the same as completely eliminating the taxes.
Check for exceptions
If you sold the house based on an unforeseen event, whether that’s employment or health, you may still be able to exclude some of the gains from your home sale. Check the full list of IRS exceptions.
Keep track of home improvements
All of the improvements you made to your home over the years factor into the cost basis (essentially what you paid for your home). This can reduce the actual profits that you’ve made, which can keep your capital gains taxes down. This includes:
- Air conditioning and HVAC installations
- New windows and doors
Hold out for longer
If at all possible, try to hold out from selling your home for as long as you can. Part of that is getting to the two-year threshold for the exclusion requirements, but even if you don’t qualify for the exclusion, it’s better for your tax rate. Long-term capital gains tax rates are significantly lower than short-term tax rates, so try to hold the property for at least one year before selling.
Taxes on a sold property can get confusing, and if you don’t know what you’re doing, you may end up paying penalties and fees on top of the owed taxes. If you are selling your home or are a first-time home buyer in Southern California, our team at Berkshire Hathaway HomeServices California Properties can guide you through the whole process and cover all your bases to ensure your peace of mind. Contact us to learn more.