Depending on how long you’ve owned your primary home (the home in which you reside), you may end up making a profit if you decide to sell. Unfortunately, you don’t get to just pocket that profit—you’ll have to pay something called capital gains tax.
Capital gains taxes can be pretty complicated to navigate. Although they are based primarily on your income and the length of time you have owned the property, it is rarely that simple.
With that in mind, the following guide will help break down capital gains taxes, including how they are calculated and what you can do to limit their impact on the profit of your primary home’s sale.
What Are Capital Gains Taxes On Real Estate?
When you sell an asset that you own, you may end up making a profit, especially if that asset has increased in value since the time you bought it. If you do end up making a profit, you’ll be taxed by the government.
For example, if you buy a house for $200,000 and then flip it for $250,000, that $50,000 profit will be subject to taxation. This tax is known as a capital gains tax. However, not all real estate is taxed the same way.
For instance, investment properties are taxed at a higher rate than primary residences. Additionally, the amount you are taxed is based on various factors, including how long you have owned the property and the income you are currently earning.
Capital Gains Tax Rate
The first thing worth noting is that capital gains tax rates vary significantly.
If you are selling your primary home, then the first $250,000 in capital gains are exempt (if you are single) under the Taxpayer Relief Act of 1997. If you are married, then the first $500,000 is exempt.
However, you must have occupied the home for at least two out of the past five years to qualify for this exemption.
For instance, if you are a single homeowner and you sell your primary residence for $400,000, after having bought it five years ago at $200,000, you will have earned a profit of $200,000. As long as you meet the exemption qualification, you will not have to pay capital gains tax on that $200,000 since it is under the $250,000 threshold.
If you do not qualify for the exemption, capital gains taxes will be based on your profits. If you are eligible but your earnings exceed the threshold, any profit past that threshold will be taxed.
For instance, if you bought your primary home for $150,000 and sold it for $500,000, that means you made a profit of $350,000. If you are single, the first $250,000 of that profit is exempt and will not be taxed, but the rest ($100,000 in this case) will be.
However, there isn’t a singular tax rate. Tax rates on all non-exempt profits vary based on the seller’s income and whether the asset is classified as short-term or long-term.
Short Term vs. Long Term Capital Gains Tax Rate
Short-term refers to assets that you have owned for less than a year. If you buy and sell a property within a year, your profits are subject to short-term capital gains taxes.
Essentially, this means that the government will treat the profit you generated as regular income. As such, you will be taxed based on your income bracket and your filing status, which means that your real estate profits could be taxed as high as 37 percent.
Assets you have owned for more than a year are considered long-term assets and are taxed at a lower rate. However, that rate is also based on your income and filing status.
There are three taxation categories if you are selling long-term real estate:
- 0% tax rate, if you are:
• Single and earning less than $40,000
• Married and filing separately and earning less than $40,000
• Married and filing jointly and earning less than $80,000
• Head of the household and earning less than $53,600
- 15% tax rate, if you are:
• Single and earning between $40,000 and $441,450
• Married and filing separately and earning between $40,000 and $248,300
• Married and filing jointly and earning between $80,000 and $496,600
• Head of the household and earning between $53,600 and $496,050
- 20% tax rate, if you are:
• Single and earning more than $441,450
• Married and filing separately and earning more than $248,300
• Married and filing jointly and earning more than $496,600
• Head of the household and earning more than $496,050
Calculating Capital Gains
It’s a bit more complicated than simply taxing the amount of profit that is not exempt from capital gains taxes. You will also need to determine your cost basis before calculating what you will owe in capital gains taxes.
To calculate what you’ll owe, you’ll need to determine the following:
A Taxable Home Sale
The first thing is to determine whether your home sale is taxable. To do this, you must figure out whether your property qualifies as your primary home or not. Either way, identify whether you will be subject to short-term or long-term capital gains taxes.
Lastly, determine if the profit you have made is taxable (for example, the profit isn’t taxable if you are a single homeowner and you earned less than $250,000 in profit from the home sale).
Calculating Cost Basis
If you determine that you are subject to capital gains tax, you will need to calculate your cost basis (also referred to as adjusted cost basis). The cost basis is the original cost of the property. Once you’ve determined the cost basis, you’ll need to calculate the adjusted cost basis.
Adjusted Cost Basis
To calculate the adjusted cost basis, add the initial cost of the property along with all expenses associated with the purchase (such as the closing costs) and all capital improvements you made (anything you’ve done to boost the value of the property, such as remodeling work or additions).
For instance, if you bought a house for $200,000 and sold it for $500,000, you might assume that you will be taxed on $50,000 of your $300,000 profit. However, if your adjusted cost basis is $250,000 or over, you’ll be exempt.
Deductible Selling Costs
Once you use the adjusted cost basis to calculate your actual capital gain, you can also deduct capital expenses. These expenses include all costs associated with selling the property (commissions, transfer fees, marketing expenses, and more).
So, if you’ve calculated that you earned a capital gain of $50,000 and your capital expenses totaled $10,000, the amount that can be taxed will actually be $40,000.
Do You Qualify For Capital Gain Exclusions?
By using your adjusted cost basis and deducting any selling costs, you can help reduce any capital gains taxes. However, you will want to be aware of any other possible exemptions that can help you out. In fact, it is helpful to know about the following capital gain exclusions before selling a house.
Is The House Your Primary Residence?
As previously mentioned, you can qualify for a significant capital gain exclusion if you are selling your primary residence. However, there is a strict definition of a primary residence.
You need to be able to prove that you lived in the house for at least two out of the last five years. If you’ve only owned the home for 18 months, then you won’t benefit from this exemption, even if it has been your primary residence for that time.
Second Home Used As Primary Home
If you own a second home that is not currently your primary residence, you can still benefit from the primary home capital gains exclusion. Essentially, the same guidelines exist. As long as you used the second home as a primary residence for at least two out of the past five years, you can benefit from the $250,000 to $500,000 capital gains exclusion.
Are You Being Forced To Sell Under Certain Circumstances?
There are also capital gain exclusions available for sellers who are forced to sell under certain circumstances. For instance, if you are displaced from your primary home due to a natural disaster then the capital gains tax may be waived.
Capital gains tax is also waived for members of the U.S military who have to sell their home while living abroad because they have been called to active duty. This exemption also includes any member of the Military Reserve who is recalled to service by executive order during a war, national emergency, or any other military operation.
Other circumstances in which capital gain exclusions may apply include being forced to move due to a change in employment, a divorce, health factors, a death in the family, or the need for assisted care in an assisted living facility or nursing home.
Did You Ever Take Depreciation Deductions On A Home Office?
Things can get a little tricky if you have a home office.
First of all, if the home office is inside the home proper (such as in one of the bedrooms or in the living room), then you can still qualify for the $250,000 or $500,000 capital gains exclusions available to those who are selling their primary residence.
However, if your home office is outside your house—meaning it is in an unattached area of your home, such as in a guest home or an unattached garage—you will owe capital gains tax on that space.
So, if your home office occupies 10 percent of your entire home’s space and it is not attached to your actual house, you must allocate 10 percent of your profit to that home office, which will then be subject to the entire capital gains tax.
Things get even more complicated if you have been taking depreciation deductions on your home office. The IRS will tax recaptured deductions at a 25 percent rate. You’ll only be exempt from this rate if your income tax bracket is below 25 percent.
Ways To Reduce Your Capital Gains Taxes
A good understanding of any capital gains tax exclusions can potentially reduce any capital gains taxes you owe on future real estate sales.
The following are a few examples of how you can do this.
Convert A Second Home To A Primary Home
If you own a second home but do not qualify for the capital expense exclusion because you only use it sporadically (for example, if you only use your second home as a vacation home), you could convert it to your primary home.
Once you’ve moved in, you’ll need to live there until you meet the qualification requirements.
Divide Ownership Of House
If you and your spouse own a house jointly, but one of you has moved out, capital gain taxes on that property may be reduced by dividing ownership between the two of you. The person moving out will then receive half the capital gains tax relief while the other person will retain a proportional share of capital gains exclusion.
Defer Taxes Via An Installment Sale
If your capital gains taxes seem too high, you can defer these taxes by undergoing an installment sale. Instead of selling the property all at once, you would require the buyer to purchase the house in several installments over time.
As a result, you will only pay capital gains taxes on each payment that is made if you break those installments up over several years.
Suspension Of The Residence Rule
The residency rule that requires you to live in your primary residence for at least two out of the past five years can be suspended based on various circumstances.
As mentioned, these include military service call-ups and certain life situations such as getting divorced, moving into a nursing home, or being forced to move due to employment changes. If you know that you may qualify for such a suspension in the future, you might want to delay the sale of your home until then so that you can take advantage of the exemption.
Use The 1031 Exchange
The 1031 exchange is a taxation law that states that you may defer capital gains and depreciation expenses if you purchase a new property with the proceeds from selling your old one. The requirements for this are as follows:
- You must have sold the capital asset within 12 months of when the replacement is purchased.
- The replacement property must be similar in usage to the capital asset. For example, if you sold a rental house because your primary residence was being foreclosed, you cannot purchase another rental home with the proceeds from selling your first rental house.
- The capital asset cannot be part of a trade or business, nor can the capital gain come from any collectibles.
- If there are gains made in addition to depreciation expenses for the old property that were not deferred as capital expense exclusions (such as if you refinanced your mortgage and paid off all owed debt on it), capital gains taxes may apply.
Understanding Capital Gains Can Help You Save Money On Home Sale Taxes
To avoid paying high capital gains taxes when selling your primary home, prepare in advance and plan for potential capital gains exclusions. By understanding these exclusions and how to qualify for them, you could end up saving a significant amount of money by reducing any capital gains taxes on the future sale of your home.