Will I Have to Pay Capital Gains Tax When I Sell My Home?

According to Internal Revenue Service (IRS) regulations, your property must be your principal residence for the sales profit to be excluded from capital gains tax. The regulations state that you must have lived in the house for at least 24 months out of the previous five years.

If you sell the house before the two years is up, you will be responsible for paying the full capital gains tax. The amount you owe will depend on how long you owned the property (short-term vs long-term).

Short-term capital gains taxes are considered ordinary income and can be as high as 37% for high-income individuals. Long-term capital gains tax rates are applied to income and tax-filing status and range from 0% to 15% to 20% or 28% for small business stock and collectibles.

You may be able to exclude some or all of your long-term capital gains tax on the profit of your home sale if you owned the home for at least two years and meet the principal residence requirements. This includes a property you converted from a primary residence to a rental property because the two-year residency rule can be met with cumulative months and does not require that the 24 months be consecutive.

If you are a widowed taxpayer, you may be able to increase your exclusion amount from $250,000 to $500,000 if you:

• Sell your home within two years of the death of your spouse.
• Haven’t remarried at the time of the home sale.
• Did not use this exclusion on another home (and your spouse did not) that was sold less than two years before the date of your current home’s sale.
• Meet the two-year ownership and residence requirements.

The 2-in-5-Year Rule states that you can count a home as your primary residence if you have lived in it for a total of 730 days (two years) or longer during the previous five years. These days do not need to be consecutive or fall into a specified period of time.

If a married couple filing jointly plans to file for the $500,000 capital gains exemption, both of the spouses must meet the primary residence criteria. For example, if a couple is recently married and one spouse only lived in the home for 12 months, the capital gains exclusion will be $250,000 and not $500,000.

Conversely, if a recently married couple is selling a home but one spouse has lived in the residence for less than two cumulative years out of the last five, then only the qualifying owner can qualify for the exclusion meaning up to $250,000 of the capital gains can be excluded.

Let’s say you are a single tax filer who bought a new condo for $300,000. You lived in it for the first year, rented the property for the following three years, and then moved back into the condo for year five after the tenants moved out. After that fifth year, you decide to sell the condo for $450,000. Because your profit is $150,000, within the $250,000 exclusion limit, you do not owe capital gains taxes.

On the other hand, if your condo sold for $600,000, you would owe capital gains tax on the $50,000 profit that exceeded the exclusion limit ($600,000 - $300,000 = $300,000). As of 2023, your tax rate on the $50,000 would be 15%.

One note: You can offset this profit with capital losses up to $3,000 from other taxable income.

The table below shows long-term capital gains tax rates for taxes due in 2024.

On the other hand, if your condo sold for $600,000, you would owe capital gains tax on the $50,000 profit that exceeded the exclusion limit ($600,000 - $300,000 = $300,000). As of 2023, your tax rate on the $50,000 would be 15%.

One note: You can offset this profit with capital losses up to $3,000 from other taxable income.

Capital gains you earn from selling real estate impact your overall capital gains tax rate each year. For example, let’s say a married couple who files taxes jointly and recently sold a home that saw tremendous appreciation over the past 15 years. In fact, they purchased their home for $300,000 and sold it for $1 million dollars. The capital gains on this sale is $700,000.

They are able to exclude $500,000 of the capital gains because they are a married couple filing jointly. This means that $200,000 is subject to the capital gains tax.

How much will they pay in taxes? By referencing this graphic, you will see that their combined capital gains income is above $553,850 (assuming they have no other capital gains to report) meaning they are in the 20% tax bracket and will owe $40,000.

Understanding the IRS exceptions to capital gains tax eligibility requirements is important. One of the most important restrictions to the capital gains tax exemption is that you can only benefit from the exclusion once every two years.

For example, if you sell two homes at once, both of which you lived in for two years in the past five years, you can only exclude capital gains tax on one of them at a time. In fact, you could only sell the second home tax-free two years after you sold the first one.

Other situations that would make the home seller ineligible for the capital gains tax exclusion include situations where:

• The home was not the seller’s primary residence for at least two years of the last five years (some exceptions apply).
• The seller acquired the property through a 1031 exchange within the last five years.
• The seller is subject to expatriate taxes.
• The seller sold a different primary residence within two years of the date of the current sale and applied the capital gains exclusion on that sale.

In most cases, real estate falls into two primary categories for homeowners: an investment or rental property or a principal residence. Your principal residence is the place where you primarily live. But let’s say you want to sell an investment property that is not your primary residence. How does this impact your capital gains tax obligations?

An investment or rental property is real estate acquired or repurposed with the intention of generating income or profits for the owner(s) or investor(s). This is different than being classified as a “second home.”

Property classified as investment property affects how it is taxed by the government and which tax deductions you can claim. According to the Tax Cuts and Jobs Act (TCJA) of 2017, you can deduct mortgage interest up to $750,000 on a principal residence or second home. However, if a property is exclusively used as an investment property, it is not eligible for the capital gains exclusion.

Before we talk about strategies for managing capital gains on investment properties, we should further differentiate rental/investment property from vacation/second homes.

Rental properties are properties leased to others with the aim of generating income or profits. Conversely, a vacation home serves primarily as a recreational retreat used for short-term stays, vacations, and leisure activities and therefore is not classified as a person’s primary residence.

Many homeowners choose to convert their vacation homes into rental properties when not in use because that income can often cover mortgage payments and other maintenance costs. However, there are important considerations to bear in mind. If a vacation home is rented out for fewer than 15 days in a year, the income does not need to be reported (and is not taxable). However if the homeowner uses the vacation home for less than two weeks annually and rents it out for the remaining time, it is categorized as an investment property.

When homeowners decide to sell a vacation home, they can potentially benefit from the capital gains tax exclusion provided they meet the ownership and use criteria set forth by the IRS. However, it's worth noting that a second home typically does not qualify for a 1031 exchange (more on 1031 exchanges below).

Before we talk about strategies for managing capital gains on investment properties, we should further differentiate rental/investment property from vacation/second homes.

Rental properties are properties leased to others with the aim of generating income or profits. Conversely, a vacation home serves primarily as a recreational retreat used for short-term stays, vacations, and leisure activities and therefore is not classified as a person’s primary residence.

Many homeowners choose to convert their vacation homes into rental properties when not in use because that income can often cover mortgage payments and other maintenance costs. However, there are important considerations to bear in mind. If a vacation home is rented out for fewer than 15 days in a year, the income does not need to be reported (and is not taxable). However if the homeowner uses the vacation home for less than two weeks annually and rents it out for the remaining time, it is categorized as an investment property.

When homeowners decide to sell a vacation home, they can potentially benefit from the capital gains tax exclusion provided they meet the ownership and use criteria set forth by the IRS. However, it's worth noting that a second home typically does not qualify for a 1031 exchange (more on 1031 exchanges below).

Qualified home sellers of a principal residence can exclude up to $250,000 (or $500,000 if a married couple filing jointly) of their capital gains from their taxes that year.

Another way to reduce the capital gains from selling a home is with adjustments to the cost basis. Your cost basis could be increased if you include fees and expenses that are associated with the purchase of the property, home improvements, and home additions. Any resulting increases to the cost basis can reduce your capital gains.

You can also use the capital losses from that tax year to offset the capital gains from the sale of your home. You may also be able to carry large capital losses forward to subsequent tax years.

The sections below discuss a few more strategies that might help you reduce or avoid capital gains taxes on your next home sale.

Sales of non-principal residences are typically subject to capital gains tax. One way a homeowner can avoid taxes when selling an investment property is by reinvesting the proceeds into a similar property using a 1031 exchange. Named after Internal Revenue Code Section 1031, this like-kind exchange enables the seller to defer the taxes on gains by putting their sales proceeds in another investment property.

The 1031 exchange is available to individuals, corporations, trusts, partnerships, and limited liability companies (LLCs) who own investment and business properties.

It's important to note that properties eligible for the 1031 exchange must be intended for business or investment purposes, not for personal use. If you choose to do a 1031 exchange, you must identify a replacement property in writing within 45 days of the sale of the first property and complete the exchange for an eligible property within 180 days of the sale.

To prevent potential abuse of the 1031 exchange and capital gains exclusion, the American Jobs Creation Act of 2004 stipulates that you must own the newly acquired property for at least five years after the exchange for the exclusion to apply.

An IRS memorandum outlines the conditions under which the sale of a second home could be partially shielded from the full capital gains tax, but it's worth noting that the criteria are stringent. Specific requirements include:

• Owning the property for a full two years;
• Renting the property out at a fair rate for at least 14 days in each of the previous two years; and
• Not using the property for personal purposes for more than 14 days or more than 10% of the time it was rented, whichever is greater, in the previous 12 months.

Given the intricacies of executing a 1031 exchange, it is advised that you seek legal counsel from a real estate attorney who is experienced in this area or from a 1031 exchange company to avoid costly mistakes and ensure your 1031 exchange aligns with the requirements of the tax code.

SMART works with your selected 1031 exchange agent to coordinate the property exchange. < a href="https://www.smartsettlements.com/contact" target="_blank">Contact us for referrals to trusted 1031 exchange agents.

The capital gains exclusion on real estate is attractive because it reduces your tax liability, and it can be one part of your plan to grow your real estate investments. To reduce capital gains taxes on the sale of additional properties, some homeowners convert a second home or rental property into a primary residence for an aggregate of two years of the last five years before selling.

Be aware that there are stipulations. For example, deductions for depreciation on gains earned before May 6, 1997, are not considered in the exclusion. Another requirement is the allocation of capital gains as defined in the Housing Assistance Tax Act of 2008, which states that a rental property that is converted into a primary residence is only excluded from capital gains for the years in which it was the principal residence. In other words, if you rented the property for three years and lived in it for two, the capital gains from the three rented years do not qualify for the exclusion.

The cost basis of a property is essentially your cost and includes but is not limited to the original purchase price, eligible expenses related to the home purchase and improvements, and specific legal fees. The cost basis helps to determine the amount of taxes you owe when you sell the property.

Here’s an example. If you purchased a home for $500,000 five years ago, made no improvements, and experienced no losses, then the cost basis when you sell will still be $500,000. Therefore, if you sell the home for $650,000, your taxable gain would be $150,000.

Many homeowners do make home improvements (cost basis increases) or incur losses (cost basis reductions) during their ownership. As such, the cost basis of their house will change over time and therefore you need to calculate your adjusted home basis before selling. Do make note that the cost basis will not change if you do any work that does not add value, provide use past one year, and/or is no longer part of the residence.

For instance, let’s say you purchased a house for $350,000. You experienced a house fire, and your insurer paid you $150,000 to rebuild. Therefore, you have a cost basis reduction of $150,000 to bring your adjusted cost basis to $200,000. You later spend $50,000 to add a bathroom to the home, and this increases your cost basis by $50,000. Your adjusted cost basis is now $250,000.

Before selling a home, be sure to consider your selling costs such as real estate agent commissions, attorneys fees, and/or transfer taxes.

The cost basis for an inherited home is the Fair Market Value (FMV) of the property at the time the original owner died. However, if an executor plans to file an estate tax return, the alternate valuation date is when the FMV is determined.

For example, you inherit a home for which the grantor paid $70,000. At the time of the grantor’s death, the home was valued at $300,000. This amount, $300,000, is now your cost basis. When you sell the house a year later, it is worth $400,000 and therefore your taxable gain is $100,000.

A seller must report to the IRS if they received Form 1099-S, a tax form that reports the proceeds from the real estate sale or exchange that results in non-excludable, taxable gains. Form 1099-S is typically issued by your real estate brokerage, closing company, or mortgage lender. If you received this form but are qualified to exclude your capital gains on the sale, inform the issuing entity by February 15th of the year after the closing.

How do you know if you do not need to report to the IRS? The following situations do not need to be reported:

• If the home sales price is $250,000 or less ($500,000 for married couples) and the gain can be wholly excluded from gross income. Additionally, the home must be proven to be the principal residence, sometimes with documentation.
• If the seller is a corporation, government or government sector, or exempt volume transferor. An exempt volume transferor is someone who has sold or will sell 25 or more reportable real properties to 25 or more parties.
• If the sale is actually a non-sale, such as a gift.
• If the transaction satisfies a collateralized loan.
• If the sale is a de minimis transfer. In other words, if the total consideration for the transaction is $600 or less.

Unless you convert your second home into your primary residence, it will be difficult to exclude your capital gains from taxes upon selling it.

An IRS memorandum outlines the conditions under which the sale of a second home could be partially shielded from the full capital gains tax, but it's worth noting that the criteria are stringent. Specific requirements include:

• Owning the property for a full two years;
• Renting the property out at a fair rate for at least 14 days in each of the previous two years; and
• Not using the property for personal purposes for more than 14 days or more than 10% of the time it was rented, whichever is greater, in the previous 12 months.

If you used the home for more than 14 days or 10% of the rented time, then the property will be considered personal and not investment. This makes it ineligible for a 1031 Exchange and will likely be subject to capital gains taxes.

When you sell a primary residence, you cannot consider a profit loss as a capital gains loss on your taxes. On the other hand, you may be able to exclude losses from the capital gains taxes when you sell investment or rental property.

Be aware that your gains from the sale of one asset can be offset by up to $3,000 or your net total loss from the losses on the sales of other assets. You might be eligible to carry over such losses in subsequent tax years.

There is another note regarding selling a property below market to a friend or relative. The IRS may consider this a gift, in which case the buyer may be subject to taxes on the difference between the cost basis when they purchased it from you and the amount for which they sell it later. This is because the buyer will inherit your cost basis, which determines the capital gains when they sell it. It’s important the the buyer knows how much you paid for the property, the amount of money spent on improvements, and any cost basis reductions.