Selling a home is a major financial decision. If you plan on doing it soon, you may be wondering about the tax implications of selling your house. Read on to learn when you need to pay taxes on a home sale and how you may be able to avoid doing so.
How capital gains tax works when selling a house
When you sell an investment for more than you paid for it, the profits you earn are called capital gains. That’s true regardless of whether you earn profits on a stock sale or the sale of your first home. Capital gains are taxed based on the type of asset sold, your tax filing status and other criteria set by the IRS.
However, to promote home ownership, the IRS allows qualifying individuals and couples to profit from the sale of a home without having to pay any capital gains taxes.
Do I pay taxes when selling my house?
Whether you’ll pay taxes on profits from a home sale — and if so, how much — depends on how long you’ve been in your home. If you’ve lived there for at least two of the last five years, you can pocket up to $250,000 in profits tax-free or $500,000 for couples filing a joint return. For anything over that, you’ll pay capital gains taxes based on current rates.
Below are some scenarios in which you will have capital gains tax obligations after a home sale.
The home wasn’t used as your primary residence
One of the IRS’s eligibility criteria for a capital gains exemption on home sales is residency. The home in question must have been your principal residence. If it was a rental property or vacation home that you never lived in full-time, then you won’t qualify for capital gains exclusion and will need to pay income taxes on any profits generated from the sale of your home.
You didn’t reside on the property for at least two years
The IRS also sets a minimum residency requirement. You must have lived in the home full-time for at least two years in order to qualify for the capital gains exemption.
However, these 24 months can be spread out across any of the last five years. If you bought a home, lived in it for two years, then transitioned it into an investment property and are only now selling it several years later, you can still qualify for the capital gains exemption.
That being said, there are some exceptions to the two-year rule. If you become disabled, are forced to sell because of a job relocation that requires you to move at least 50 miles away, need to seek medical treatment or care for a sick relative, or face other “unforeseen circumstances,” you can pro-rate the taxes on the profit. Check IRS rules and consult a tax advisor in these scenarios because it’s complicated.
You haven't owned the home for two or more years
You also need to have owned the home for at least 24 months. For assets owned less than a year, you’ll pay taxes at your regular tax rate. Long-term gains are taxed depending on your income. This will apply if you have owned the home for over a year but not quite two years or otherwise fail to meet the IRS’s eligibility requirements for capital gains exemption.
You purchased your home through a 1031 exchange within the past five years
The IRS allows individuals to exchange similar properties for one another without incurring capital gains taxes through a mechanism called a 1031 exchange. If you purchased the home you want to sell through a 1031 exchange, then you can’t claim the capital gains tax exclusion if you’re selling it within five years of the purchase date. You can review this guide covering the 1031 exchange timeline to learn more.
Expatriate taxes apply to you
If you’re subject to the expatriate tax, you are automatically disqualified from capital gains exemption, even if you meet all of the other eligibility criteria. The expatriate tax applies to individuals that have given up their U.S. citizenship or long-term residency for federal tax purposes.
You already used the capital gains tax exclusion on another home within the last two years
Finally, you will also need to pay capital gains tax if you already used another capital gains tax exemption within the last two years. You may have done this if you bought the home that you’re trying to sell through a 1031 exchange, as defined in the earlier section.
How much time after selling a house do you have to buy a house to avoid the tax penalty?
If you anticipate incurring a capital gains tax penalty from your home sale, you may be able to avoid it through a 1031 like-kind exchange. The IRS gives home buyers 180 days to buy a new home with the proceeds from a previous sale. If you meet that timeline, you can apply for a 1031 exchange to avoid the capital gains tax from your initial home sale.
How to avoid capital gains tax when selling a house
There are several strategies you may be able to use to avoid capital gains taxes when selling a house. Here are three that may work for you.
1. Reinvest in a similar property through a 1031 exchange
If you’re interested in selling one investment property and purchasing another, you may qualify for a 1031 exchange to avoid capital gain taxes. The IRS mandates that both properties must meet certain requirements to be eligible.
For example, the properties must be held for investment or business purposes and not personal use. Any property used for primarily personal use won’t qualify for a 1031 exchange.
Additionally, both properties must be similar enough to qualify as “like-kind.” The IRS defines this as similar nature, character or class. Quality doesn’t matter for 1031 purposes, and most real estate property will be considered like-kind to other real estate properties.
2. Make your second home your primary residence for at least two years before selling it
You may also want to consider living in an investment property for two years before initiating your upcoming real estate transaction. Making the home your primary residence for at least 24 months within the last five-year period can help you qualify for the capital gains tax exemption when you decide to sell — even if you initially purchased the property for investment purposes.
3. Benefit from capital improvement deductions
You may also be able to benefit from capital improvement deductions when selling a home, even if you don’t qualify for the standard exemption for taxes on capital gains. According to the IRS, these are permanent improvements to the property that increase its value. They must:
- Add substantial value to your home (as compared to the original purchase price)
- Prolong the useful life of the property
- Last permanently
The cost of capital improvements isn’t taxed on the sale of a home directly. Instead, it gets added to the cost basis of your home. These additions can potentially decrease the amount of profits that you pay capital gains taxes on if you fail to meet other criteria for exemption.
For example, imagine you spent $100,000 on renovations and earn $150,000 from the sale of your property. You may be able to deduct up to the full $100,000 you put into the property from your taxable capital gains. This would lead to you paying capital gains on $50,000 in profits instead of $150,000. This can get complicated, however, so it may be worth consulting with a tax expert before trying to use this strategy.
The importance of understanding the tax implications of selling a house
Understanding the tax implications of selling your home is important because it influences how profitable the sale will be and may impact your selling price. If you can avoid capital gains taxes, you could save thousands of dollars or more.
The first step in this process is learning how much you stand to gain from the sale of your home. To calculate your gain, first subtract selling expenses, such as agent commissions and other closing costs, from the sale price. Then you need to calculate your “basis.” This is what you paid for your home, plus some of the closing expenses from the purchase, such as title insurance and recording fees (but not loan points or lender fees), and the costs of any permanent improvements, like a swimming pool or new addition. See IRS Publication 523 for complete details.
Once you figure out your gain, you can consider whether you qualify for a capital gains tax exemption based on the criteria covered throughout this article. If you don’t, then your home sale taxes will be determined by your income tax rate and how long you held the home.
Summary: Will you pay income taxes on the sale of your home?
Whether you have to pay taxes or not depends on a number of factors. If it’s a primary residence you’ve lived in for more than two years, there’s a good chance you can avoid paying capital gains taxes. But if you’re selling an investment property, it may be more challenging to qualify. It can be helpful to speak with a tax professional to learn more about your options.