By Joe Dyton, WCI ContributorSelling your home for more than you paid for it can feel like a victorious moment. And for the most part, it is—after all, you just turned a profit, right? In some instances, however, the profitable transaction can feel bittersweet because the Internal Revenue Service (IRS) may want a piece of that windfall, depending on how much you made from the deal.
The IRS could get involved because when you profit from a home sale, the money earned is deemed capital gains, which are taxable. How much you’d have to pay or whether you’d have to pay capital gains tax at all depends on if your profit meets a certain threshold—along with other factors.
A successful real estate sale should be a call for celebration, but there’s always a chance owed taxes could rain on your parade. Keep reading to learn how capital gains taxes work with home sales, when you have to pay capital gains tax, and how you could avoid paying them.
What Is Capital Gains Tax?
When you sell your home or other assets, such as stocks and bonds, for a profit, the profit is considered a capital gain. A capital gains tax is the tax you have to pay on those newfound funds. Capital gains are categorized as short-term (from sold assets you’ve had less than a year) and long-term. Short-term capital gains are taxed at the same rate as your regular income. Meanwhile, long-term capital gains are usually taxed at a lower rate, encouraging people to hold onto their assets for longer periods of time. Outside of the highest-paid taxpayers, most people’s standard income tax rate is higher than the capital gains tax rate (paid on assets held onto for longer than a year).
How the Capital Gains Tax Works with Your Home
When you sell your home for more than you paid for it, you suddenly have a capital gain, and you owe tax on it in most cases. But there are exceptions. Going back to the benefit of maintaining assets longer, for example: if you’re selling your primary residence and have lived there for at least two of the past five years prior to selling, you could be eligible for a primary residence exclusion.
The Section 121 Exclusion allows homeowners who get a capital gain from selling their main residence to exclude $250,000 of that profit from their income (for single filers) and up to $500,000 of their capital gain for joint filers.
So, if you bought a house for $400,000 and sold it for $600,000 (and lived there for at least two of the last five years), your $200,000 profit wouldn’t be subject to the capital gains because it’s less than the $250,000 exclusion amount.
On the other hand, if you’re a single tax filer and sold that same $400,000 home for $800,000, you’d owe capital gains tax on $150,000 ($400,000 minus the $250,000 Section 121 exclusion). How much capital gains tax you owe also depends on your income to go with how long you owned your home and your tax filing status.
More information here:
Short-Term vs. Long-Term Capital Gains
When Do You Have to Pay the Capital Gains Tax?
When your capital gains tax bill is due after your home sale can vary. The tax itself goes into effect once you’ve sold the asset—in this case, your home. However, you can report the tax and pay it when you file your federal tax return in April as an individual. You do not have to pay the tax at the time of the sale. If you expect to owe more than $1,000 in taxes, however, you might be required to make estimated tax payments over the course of the year.
Do You Pay Capital Gains Tax on a Home Sale?
There’s a chance you’ll have to pay capital gains tax on your home sale, but it’s not a guarantee. It depends on the details of the transaction. Capital gains tax is based on any profit you make from the sale, not the sale price itself. If you end up selling your house at a loss, there’s no capital gain to tax. Plus, you could wind up exempt from the tax if your profit falls below that $250,000 or $500,000 exclusion, depending on your marital status.
However, the capital gains tax on your home sale is all but guaranteed if your profit exceeds $250,000, you’ve lived in your home for less than two years, or if you sell a house that isn’t your primary residence.
How Much Is the Capital Gains Tax?
Look at your income when you try to determine how much you’ll pay in capital gains taxes after you sell your home. Your earnings will play a key role in how much you’ll owe the IRS if you profit from the sale. For most taxpayers, the capital gains tax rate won’t exceed 15%, according to the IRS. You may not have to pay a capital gains tax rate at all if your taxable income is:
- $47,025 or less (single and Married Filing Separately)
- $94,050 (Married Filing Jointly and qualifying surviving spouse)
- $63,000 (head of household)
Meanwhile, the most common 15% capital gains tax rate applies to those with a taxable income of:
- More than $47,025-$518,900 (single filer)
- More than $47,025-$291,850 (MFS)
- More than $94,050-$583,750 (MFJ and qualifying survivor spouse)
- More than $63,000-$551,350 (head of household)
If your taxable income is more than the thresholds for the 15% capital gain rate, you’ll pay a 20% rate.
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Life in the 0% Long Term Capital Gains Bracket
How to Calculate Capital Gains Tax on a Home Sale
You’ll be looking at a lot of numbers when you sell your home. Be sure to add how much you might have to pay in capital gains tax to the list so you’re not caught off guard.
You can calculate your capital gains tax following your home sale in a few steps. First, figure out your basis: the purchase price for your home plus commissions and fees you have to pay. Then, determine your net proceeds: what your home sold for minus any commissions or fees.
Once you have your basis and net proceeds figures in place, take the basis (what you bought the house for) from the realized amount (the sale price) to get the difference. If that figure is more than your purchase price, you have a capital gain. Now that you have that number, you can determine if you’re eligible for the previously mentioned exclusion, look at your taxable income, and get your capital gains tax rate, etc.
Capital Gains Taxes on Investment Properties
One reason the Section 121 Exclusion specifically mentions primary residences is because there’s always the chance an individual has more than one piece of real estate in their portfolio. In the case of an investment property, you can’t leverage this exclusion since it’s not your main living space (unless you make it your primary residence). That means you could face a significant capital gain tax; your profit could be taxed up to 25%, according to Section 1250 of the US Internal Revenue Code.
There are a few strategies you could implement to either avoid or at least reduce your capital gain tax if you sell an investment property:
- Make the property your primary residence so you can leverage the home sale tax exclusion.
- Tax-loss harvesting—sell the property for a loss to help offset profits from another property.
- Use a 1031 exchange—take the income from a sold investment property to buy another one that has the same or greater value. You can avoid taxes on previous depreciation deductions.
How to Avoid Capital Gains Tax on a Home Sale
The Section 121 principal residence exclusion can help you avoid paying capital gains tax when you sell your home, but it’s a limited option. If your profit exceeds $250,000 as a single tax filer (or $500,000 for a joint filing), you lose that benefit.
Fortunately, there are other ways you can avert the capital gains tax on your home sale profits. For example, home improvements—such as putting on a new roof or renovating your kitchen—can increase your home’s basis and, in turn, reduce your capital gain (renovation expenses can be added to your initial purchase price). You could also deduct selling costs, like your realtor’s commission and legal costs, to lower how much of your gain will be taxed. Gifting your home to a family member could transfer the tax liability to them, and if they are in a lower tax bracket than you, there’s an opportunity to reduce the capital gains tax.
More information here:
How to Reduce Capital Gains on Property Sales
The Bottom Line
Selling your home for a healthy profit is a grand accomplishment that can be dampened by capital gains tax. Depending on how much you sell your home for, your tax filing status, and your income, you could avoid paying capital gains tax altogether. Even if you can’t, be sure to talk with a professional who can help you find ways to decrease your tax bill and hold on to more of your hard-earned money.
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