Selling Your Home? What to Know About Capital Gains Tax

One of the best advantages of owning a home is property appreciation. Real estate is one of the few purchases that can increase in value when held for long periods. On top of property appreciation, owners can implement high ROI home upgrades to boost their resale value further. It's called a capital gain when someone sells their home for more than they paid for it. As a general rule, capital gains are taxable. However, home sellers can reduce their taxable capital gains to make the most of their sales. Keep reading to learn everything you need to know about capital gains tax when selling a home.

For informational purposes only. Always consult with an attorney, tax, or financial advisor before proceeding with any real estate transaction.

Understanding Capital Gains: What They Are, How They're Calculated & Who Must Pay Them

Capital assets are stocks, bonds, cars, yachts, homes, and many other types of assets. When someone sells a capital asset for a profit, they usually have to pay taxes on that profit. Since homes tend to appreciate, most home sales involve a capital gain.

The capital gain on a house is usually less than just the sale price minus the original price. It's the sales proceeds minus the basis. The sales proceeds are left over after paying a down payment, commission, and closing costs. In contrast, the basis is the original cost of buying the house, including the buyer's closing costs, plus the cost of any improvements made during the period of homeownership. For example, homeowners who implement energy-efficient home upgrades can include the cost of those in the basis.

Taxpayer Relief Act of 1997: How It Changed Capital Gains Taxation for Real Estate

Because of the Taxpayer Relief Act of 1997, most home sellers are exempt from capital gains tax. Before this act, homeowners were required to pay total capital gains tax unless they purchased an equally valued replacement home right after selling.

The seller of a primary residence may exempt $250,000 of profit from capital gains tax if they're single and $500,000 if they're filing jointly. For the home to be considered a primary residence, the seller must have lived in it two out of the past five years. It doesn't have to be two consecutive years; they could have lived there in two one-year stints.

Also, a seller who claims the capital gains exemption must wait two years before claiming it again. Sometimes exceptions are made for military service, the death of a spouse, or job relocation.

It's challenging to avoid capital gains tax on a vacation home or seasonal home. Generally, one would have to move into the home in compliance with the two-in-five rule.

The $250,000 or $500,000 exemption is not allowed on investment properties. While the sale of an investment property is subject to the tax, there are ways to reduce, defer or eliminate the tax.

One is to offset the capital gain with capital losses. This can be done with other capital investments that have lost money, such as stocks, bonds, or other real estate. Also, losses from previous years can be carried over to the year of the home sale.

Another tool for investment property owners is the 1031 exchange. 1031 exchange rules dictate that a seller can defer the tax by rolling over the proceeds of a sale into a similar investment property. There's no limit to how many times the proceeds can be rolled over. Capital gains taxes can be delayed indefinitely.

Another way to avoid capital gains tax is to own the property for a lifetime then pass it to heirs. The property is inherited at its stepped-up value. If the heirs sell in the future, they'll have to pay tax only on the gain since they inherited it.

How Much Is Capital Gains Tax?

When an asset has been owned less than a year, its sale produces a short-term capital gain. These are taxed as ordinary income at whatever the seller's tax bracket dictates, which can be up to 37 percent. Assets held more than a year produce long-term gains and are generally taxed at a lower rate. The exact rate depends on the taxpayer's income and filing status and can be between zero and 28 percent.

If the single owner of a primary residence has a cost basis of $400,000 and sales proceeds of $800,000, there's $400,000 of capital gain. The seller may exempt $250,000 of the gain but owe taxes on the other $150,000. This money will be taxed at the appropriate long-term rate.

There will be no capital gains tax for most homeowners who sell the property they've occupied for many years. However, if a property has vastly appreciated, or if it's been something other than a primary residence, there may be a capital gains tax to be calculated and paid.

Optimize Your Real Estate Transactions for Capital Gains Taxes

Home sellers should understand the basics of capital gains taxes to make the most of their profits. The Taxpayer Relief Act of 1997 allows most homeowners to avoid paying taxes on their home-sale profits, but there are a few things homeowners need to know to take advantage of this tax break. By understanding how capital gains taxes work and what exemptions may be available, homeowners can keep more money in their pockets after selling their homes. If you're looking to sell your home soon, make sure you consult with an accountant or tax specialist who can help you navigate these waters and ensure that you don't pay any more taxes than necessary.

For informational purposes only. Always consult with an attorney, tax, or financial advisor before proceeding with any real estate transaction.