Paying taxes is a chore, but finding a break here or there can make it feel less daunting. If you’re selling your home this year, you may stand to make a nice profit, but the IRS is assuredly lurking. Paying taxes for these capital gains is one of the common consequences of selling a house, so it's common for savvy homeowners to want to avoid them.
The IRS considers homes and real estate to be capital assets, making them subject to capital gains tax, which can be a real nuisance in the seller’s market of the past two years. Fortunately, thanks to the Taxpayer Relief Act of 1997, many homeowners can pocket the profit without paying capital gains tax — if the proceeds are under a certain limit and the home meets other qualifying criteria.
A capital gains tax is a levy on the profit from the sale of an asset or investment. It is assessed on the difference between what you paid for the asset (cost basis) and what you sold it for (sale price). Capital gains taxes most often apply to investments like stocks and bonds, but also apply to material assets like cars, boats, and real estate.
Capital gains tax rates are dependent on several factors like:
The last bullet, your profit from home sale, is particularly important; home sellers can make use of certain tax exemptions to reduce their tax burden. We’ll discuss more of the nuances of the tax assessment below, but for now, let’s assume you purchased a home two years ago for $425,000 and sold it for $500,000 today. Your profit, or capital gains, would be $75,000, and you’ll need to report on your 2022 taxes.
When you sell property that you’ve owned for less than a year, then your profit, called short-term gains, will be taxed as regular income. That means you could pay a hefty sum, based on where you fall in the income tax brackets.
When you sell property that you’ve owned for more than a year, then your profit is considered long-term capital gains. You’ll be subject to long-term capital gains tax rates, which are much easier to swallow than income tax rates.
There are only three capital gains tax brackets: 0%, 15%, and 20%. Similar to how ordinary tax brackets work, you only pay a given tax rate for the amount of capital gains income that falls within that bracket.
For example, as a single filer, if you made $75,000 in profit this is how your capital gains would be taxed.
However, you may not actually have to pay anything, if you can claim the home sale exclusion.
The Taxpayer Relief Act of 1997 allows homeowners to write off up to $250,000 of capital gains (or $500,000 for married couples filing together). It’s a major exemption from real estate capital gains tax on a single home.
But, in order to claim the exemption, you must meet one important criteria. Your home must be a primary residence, meaning you must have occupied it for at least two of the last five years. So if you bought a home last year, and your local market is on fire, selling it for a major profit is a bad idea. You’ll owe capital gains tax.
That said, those two years in residence don’t have to be consecutive. Married taxpayers filing jointly must each meet the two year in five rule individually.
You will lose the $250,000/$500,000 exclusion if any of these factors are true:
Let’s return to our example from earlier — the house you purchased two years ago for $425,000 and recently sold for $500,000. Let’s assume that this house was your primary residence that you lived in for those two years. Your profit was $75,000, well below the $250,000/$500,000 threshold for exclusions. That means that you’re exempt from paying capital gains taxes on your profits from the home sale.
Unfortunately, rental properties don’t qualify for the exclusions provided by the Taxpayer Relief Act of 1997. That means that homeowners have to pay tax on the entire profit, without the option to exclude $250,000/$500,000.
If you’re thinking of renting or selling your house, take capital gains tax costs into account. And if you’ve owned your rental property for less than a year, try to hang on to it for at least 12 months before selling or you could get a tax bill of up to 37%. That’s because selling a property that you’ve owned for less than a year is taxed as ordinary income, which has a higher tax rate than capital gains taxes.
The primary means of avoiding capital gains tax is to have owned the house and lived in it as your primary residence for at least two years before selling it to qualify for the homie sale exclusion. There are also other ways to avoid or reduce capital gains tax.
The price you paid for your home is your cost basis. Making adjustments to this number can reduce your overall gain, ensuring that you fit inside the exclusion maximum or helping you lower what you owe in capital gains tax. There are two main ways to do this:
You must keep organized records documenting these costs if you choose to make these adjustments. They will provide crucial supporting evidence in the event that you’re audited.
A 1031 exchange is named after IRS Code Section 1031, which allows for the exchange of like property with no other consideration or like property including other considerations, like cash. That means you can avoid paying taxes on the sale of your home by reinvesting the proceeds into a similar home, within 180 days, through a 1031 exchange.
According to the IRS, “Properties are of like-kind if they’re of the same nature or character, even if they differ in grade or quality.” So you won’t need to buy a house that, say, costs just as much as your previous home in order to qualify for this exchange. That said, your replacement property needs to be of equal or greater value for you to receive the full benefit of the exchange.
In this type of transaction, the capital gains tax is deferred, not eliminated, so you may eventually owe if you don’t use a 1031 exchange on your next home. It’s a complex process, so it’s a good idea to work with a 1031 exchange company if you plan to go this route.
We touched on this method of claiming the capital gains tax exclusion earlier, but how do you actually do it?
This is a confusing stipulation, we know, and one that is unique to every situation. A tax professional is best equipped to help you earmark gains so you don’t claim the entire profit on your sale of a property and risk getting audited by the IRS.
It’s extremely difficult to avoid paying at least some capital gains tax on an investment property. If it’s a vacation home, you will have to pay capital gains taxes on the sale. Again, a tax expert can help you navigate this complex path.
Nobody wants to pay taxes that they don’t have to. When you make a windfall profit by selling your home, it’s just fiscally smart to mitigate your tax burden. While there are laws in place to help you avoid paying capital gains tax when selling a home, you may start to run into challenges when selling vacation homes or investment properties. There are still ways to lessen your tax burden, however, if you’re ready to get into some complex tax law.
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