When selling a home, do you have to pay capital gains tax? Depends, really. If you sell a home that has increased in value because it is a capital asset, you might have to pay capital gains tax. However, most homeowners are exempt from having to pay it thanks to the Taxpayer Relief Act of 1997.
If you are single, the first $250,000 of profit is free of capital gains tax (excess over cost basis). There is a $500,000 exemption for married couples.
There are some limitations, though. Learn more about the specifics below, including the records you must maintain while owning a home to help reduce any potential tax liabilities.
What You Should Know?
If you are single and sell your principal house, you are not required to pay capital gains taxes on the first $250,000, or $500,000 if you are married and filing jointly.
Just one exception per two-year period is permitted.
To the $250,000 if you’re single or $500,000 if you’re married and filing jointly, you can add your cost basis and any modifications you make to the house.
How Much Is Real Estate Capital Gains Tax?
According to Internal Revenue Service (IRS) regulations, your property must be regarded as your primary residence in order again for sale of it to be excluded from capital gains tax. According to these regulations, you must have lived in the house for at least 24 months out of the previous five years.
You would be forced to pay the full capital gains tax, depending on how long you held the residence, if you bought a house and sold it after a year due to a sharp increase in value.
Tax rates on short-term capital gains can reach 37% for high-income individuals when treated as regular income.
For small business stock and collectibles, long-term capital gains tax rates range from 0% to 15% to 20% or 28%, depending on your income and tax-filing status.
However you could be able to avoid part or all of the long-term capital gains tax that would be due on the profit if you’ve held your house for at least two years and comply with the primary residence requirements. Married couples filing joint returns may subtract up to $500,000 of the gain, while single taxpayers may remove up to $250,000 of the gain.
Because the two-year residency requirement only needs to be met in cumulative months rather than consecutive years, this regulation even enables you to turn a rental home into your primary residence.
The exclusion amount for widowed taxpayers may rise from $250,000 to $500,000 if they satisfy all of the requirements listed below.
- Within two years after their spouse’s passing, they sell their house.
- At the time of the sale, they had not remarried.
- When a different house was sold less than two years prior to the sale of the present house, neither the seller nor their deceased spouse choose to invoke the exclusion.
- They satisfy the two-year residency and ownership criteria.
Rule of Two in Five Years
Determining which house is the taxpayer’s primary residence is important for those who own multiple properties. Only one’s primary house is eligible for the exception, according to the IRS, but there is considerable flexibility in which home qualifies. This is when the two-in-five-year rule kicks in. In plain English, this indicates that a home can count as your primary residence if you resided in it for a total of two years, or 730 days, during the previous five years. It is not necessary for the 24 months to fall into a certain period of time.
Nevertheless, married taxpayers filing jointly must have both spouses satisfy the requirements. Even if one of the married pair had owned the home for a long time, they would not be eligible for the $500,000 exception if they were newly wed.
How Houses Affect Capital Gains Tax
Assume you spend $30,000 on a brand-new apartment. After the renters walk out, you move in for another year after renting the house for the previous three years. You sell the condo for $450,000 after five years. The profit ($450,000 – $300,000 = $150,000) does not exceed the exclusion level, hence no capital gains tax is owed. Imagine an alternate scenario where local house values rose dramatically.
In this case, you receive $600,000 for the apartment you sell. $50,000 ($300,000 profit minus $250,000 IRS exclusion) is subject to capital gains tax. For 2023, if your income is between $44,626 and $492,300, your tax rate is 15%.
If you have capital losses in other places, you can use up to $3,000 of those losses from other taxable income to offset the capital gains from the sale of the residence.
Prerequisites and Limitations for the Selling of a Principal House
If you are eligible according to the IRS, you can sell the house without paying capital gains tax. The qualifying standards, which are listed on the IRS website, do have certain exclusions.
Your ability to take use of this exemption just once every two years is the primary significant constraint. You cannot sell both of your properties tax-free until more than two years have gone since you sold the first one if you own two homes and have resided in each of them for at least two of the past five years.
The Taxpayer Relief Act of 1997 made a major difference in the effects of house sales that benefited homeowners. Before the legislation, in order to avoid paying capital gains tax, sellers had to roll the whole sale price of one house into another within two years. This is no longer the case, and the seller is free to spend the selling earnings as they see appropriate.
When Is the Entire Tax Due on a House Sale?
Not everyone is eligible to benefit from capital gains exclusions. When one sells a home, gains are entirely taxed.
- Within five years, the property was bought through a 1031 exchange (more on that below).
- Taxes for foreign residents are due from the vendor.
- Prior to the sale, the property was not utilized as the seller’s primary residence for at least two of the previous five years (some exceptions apply).
- Within two years on the selling date, the seller sold another house and applied the capital gains exclusion to that sale.
Example of a House Sale Capital Gains Tax
Think about the following instance: married couple Susan and Robert spent $500,000 for a house in 2015. The homes in their area saw big price increases and great expansion. They sold their house in 2022 for $1.2 million after deciding to take advantage of the increase in housing values. The transaction resulted in capital profits of $700,000.
They were able to deduct $500,000 of the capital gains as a married couple filing jointly, leaving just $200,000 due to capital gains tax.
They fall into the 20% tax rate due to their combined income. their capital gains tax was $40,000 as a result.
Tax on Investment Property Capital Gains
Real estate is often divided into three categories: primary dwelling, investment property, and rental property. The property that an owner uses as their main dwelling is known as their principal residence. But what if the house you’re selling isn’t your primary abode but rather an investment property? Real estate acquired or renovated with the intention of generating income or a profit for the owner(s) or investor is known as an investment or rental property (s).
Being categorized as an investment property rather than a second home has an impact on how taxes are calculated and which tax breaks, including mortgage interest deductions, are available. In accordance with the Tax Cuts and Jobs Act (TCJA) of 2017, the mortgage interest on a primary property or second home can be written off up to $750,000. However, a property does not qualify for the capital gains exclusion if it is only utilized as an investment property.
Under the 1031 exchange, capital gains tax deferrals are permitted for investment properties provided the profits of the sale are utilized to buy a like-kind investment.
Moreover, capital gains from the sale of investment assets can be reduced by capital losses sustained during the tax year.
So, even when investment properties are not eligible for the capital gains exclusion, there are methods to lower or completely avoid paying capital gains taxes.
Vacation home versus rental property
Real estate that is rented out to other people in order to make money is called a rental property. Real estate used for leisure purposes and not as the primary dwelling is referred to as a vacation house. It is typically used for short-term visits, such as vacations.
While not in use, homeowners frequently turn their vacation houses into rental residences. The rental revenue can pay the mortgage as well as other upkeep costs. There are a few things to bear in mind, though. The income is not required to be reported if the rental period is shorter than 15 days. A vacation house is regarded as an investment property if the owner occupies it for no more than two weeks of the year while renting out the remaining time.
If they adhere to the IRS ownership and usage requirements, homeowners who sell vacation homes can benefit from the capital gains tax exclusion. But, a second house often won’t be eligible for a 1031 exchange (see below).
How to Reduce Capital Gains Tax When Selling a Property
Want to pay less in taxes when you sell your house? Taxes on the sale of your property can be avoided or reduced in certain circumstances. Up to $250,000 ($500,000 for married couples filing jointly) of the gain may be excluded from taxes if you have owned and resided in your home for two of the last five years.
Modifications to the cost basis may also aid in lowering the gain. You can increase your cost basis by adding fees and costs related to the home’s purchase, home upgrades, and additions. The capital gains are subsequently decreased by the resulting rise in cost basis.
In addition, capital gains from the sale of your house may be offset by capital losses from other assets. Even carrying over sizable losses to successive tax years is possible.
Let’s look at some further methods for lowering or avoiding capital gains taxes on property transactions.
To reduce taxes, use 1031 exchanges
By using a 1031 exchange to reinvest the sale profits into a similar property, homeowners can avoid paying taxes on the sale of their house. This like-kind exchange, which takes its name from Internal Tax Code Section 1031, permits the exchange of like property for other property, such as cash, or for like property plus additional considerations. The 1031 exchange enables the deferral, rather than elimination, of the tax on the gain on the sale of a property.
Owners of investment and commercial real estate, including corporations, people, trusts, partnerships, and limited liability companies (LLCs), may benefit from a 1031 exchange when trading in one type of property for another.
The properties that are up for exchange under Section 1031 must be for use in a company or as an investment, not for private use. After 45 days of the sale, the party to the 1031 exchange must name in writing alternative properties, and within 180 days of the sale, the exchange must be completed for a property similar to the one in the notice.
The American Jobs Creation Act of 2004 says that the exclusion only applies if the swapped property had been kept for at least five years following the transaction, in order to prevent someone from abusing the 1031 exchange and capital gains exclusion.
The sale of a second property may be exempt from paying the full capital gains tax, according to an IRS letter, but there are significant requirements. There would have to be a swap of one investment property for another. The property must have been held by the taxpayer for two full years, rented out for at least 14 days each of the preceding two years at a reasonable rental rate, and used for personal purposes no more than 14 days in any 12-month period, or 10% of the time it was otherwise rented, whichever is larger.
Working with a reliable, full-service 1031 exchange provider has benefits since implementing a 1031 exchange may be a complicated procedure. These services typically cost less than those provided by attorneys who bill by the hour because of their size. You may prevent costly mistakes and guarantee that your 1031 exchange complies with the tax rules by dealing with a company that has experience with these types of transactions.
Make Your Second House Your Primary Residence
Many homeowners find capital gains exclusions appealing, to the point that they could want to make the most of it throughout the course of their lifetime. As rental properties and profits on non-principal residences do not have the same exemptions, many have looked for strategies to lower their capital gains tax when selling their properties. Converting a second house or rental property into a primary residence is one approach to do this.
Before selling and benefiting from the IRS capital gains tax exclusion, homeowners are permitted to convert their second house into their primary residence for a period of two years. Conditions do, however, apply. Gains realized prior to May 6, 1997 will not be included in the exclusion if depreciation deductions are made.
The capital gains exclusion for a rental property that has been converted to a primary residence is only permitted under the Housing Assistance Tax Act of 2008 while the property was being utilized as a principle residence.
The whole ownership term receives the capital gains. The allotted area comes under non-qualifying use when being used as a rental property and is not qualified for the exclusion.
The Tax Benefits of Installment Sales
The goal is to sell an investment for a big profit. The matching tax on the sale, however, might not be. There is a solution for owners of vacation homes and rental properties to lessen the tax burden. The property owner may decide on an installment sale option, in which some of the gain is delayed over time, to lower taxable income. During the duration of the contract’s set term, a certain payment is created.
The principle portion of each payment, which represents the nontaxable cost basis, is made up of principal, gain, and interest. The interest is taxed as ordinary income. As comparison to the tax on a lump-sum return of gain, the tax on the fractional share of the gain will be lower. Long-term or short-term capital gains taxation will depend on how long the property owner owned it.
How to Determine a Home’s Cost Basis
A home’s cost basis is the price you paid for it (your cost). Included are the purchase price, a number of home-related charges, remodeling costs, a number of legal fees, and more.
Example: Rachel paid $400,000 for her house in 2010. For the course of her 12-year residence, she did not make any additions or suffer any losses. She sold her house in 2022 for $550,000. Her cost basis was $400,000, and she had a $150,000 taxable gain. She decided to omit the capital gains, therefore she didn’t have to pay any taxes.
Adjusted Home Basis: What Is It?
A home’s cost base might fluctuate. As you get a return on your investment, you have to reduce your cost basis. For instance, let’s say you paid $250,000 for a property and later suffered a loss due to a fire. Your cost basis drops to $150,000 (initial cost basis of $250,000 less $100,000 insurance payout) after your home insurer makes a payment of $100,000.
Your cost base will not grow if you make repairs that are required to keep the house in good condition but add no value, have a short useful life (less than a year), or are no longer a part of the house.
Similar to how various occurrences and actions might raise the cost base. Take the $15,000 you spent on adding a bathroom to your house. The sum that you spend on house improvements will be added to your new cost base.
Grounds for Taking Over a House
The cost basis of a house that you inherit is its fair market value (FMV) at the time of the previous owner’s passing. Let’s take the scenario where you receive a house that cost the original owner $50,000 as an example. The house was worth $400,000 when the first owner passed away. After six months, you sell the house for $500,000 in total. ($500,000 sales price – $400,000 cost basis) yields a $100,000 taxable gain.
If the executor files an estate tax return and chooses that option, the FMV is established on the date of the grantor’s passing or on the alternative valuation date.
IRS Reporting of Home Sale Profits
If you got a Form 1099-S detailing the sale’s revenues or if there was a non-excludable gain, the sale of your house must be reported.
Real estate transactions are reported on Form 1099-S, an IRS tax document. Typically, the real estate agent, closing service, or mortgage lender issuing this paperwork. Inform your real estate professional by February 15 of the year after the transaction if you satisfy the IRS requirements to avoid paying capital gains tax on the sale.
Which transactions are exempt from reporting? According to the IRS:
- If the sales price is $250,000 or less ($500,000 for married individuals) then the gain is entirely excludable from gross income. Also, the homeowner must certify that their primary dwelling satisfies the criterion. The veracity of these attestations must be certified to the real estate professional.
- If the transferor is a business, an exempt volume transferor, or a government agency or department (someone who has or will sell 25 or more reportable real estate properties to 25 or more parties)
- Non-sales items like presents
- A deal made to pay off a secured loan
- A de minimis transfer is one in which the entire consideration for the transaction is $600 or less.
Divorce and Military Personnel Circumstances
The usage criterion for capital gains tax exemptions on house sales might be made more difficult for a taxpayer to meet if they are divorced or are moved as military personnel. Thankfully, there are factors to take into account.
When determining whether they meet the usage criterion, the divorced spouse who is given possession of a residence may add up the years that the previous spouse possessed it. Moreover, if the grantee is the owner of the property, the usage restriction may also apply to the period during which the ex-spouse resides there before the property is sold.
Military Personnel and a Few Government Representatives
While on duty, military troops, some government employees, and their spouses can choose to postpone the five-year requirement for up to ten years. In essence, the service member is eligible for the capital gains exclusion (up to $250,000 for single taxpayers and up to $500,000 for married taxpayers filing jointly) as long as they live in the house for two out of the 15 years.
Can There Be Tax-Free House Sales?
Yes. Sales of homes may be exempt from taxes if certain conditions are met:
- For two of the past five years, the seller had to have owned the property and lived there as their primary residence (up to the date of closing). It is not necessary for the two years to be consecutive to qualify.
- In order to qualify for the capital gains tax exclusion, the seller must not have sold a house in the previous two years.
- The seller does not owe taxes on the sale of their home if the capital gains do not reach the exclusion threshold ($250,000 for singles and $500,000 for married couples filing jointly).
How Can I Sell My Home Without Paying Taxes?
You may avoid paying taxes on the selling of your home in a number of ways. To name a few:
- Equalize your capital gains and losses. You can use capital losses from prior years to offset profits in subsequent years.
- If you’re eligible, make use of the IRS principal residence exclusion. You may exclude up to $250,000 of the capital gains if you’re a single taxpayer, and up to $500,000 if you’re married and filing jointly (certain restrictions apply).
- Use a 1031 exchange to transfer the sale profits into a comparable investment within 180 days if the house is a rental or investment property.
What Taxes Must I Pay When I Sell My House?
Your tax rate and the size of the gain from selling your home determine how much tax you will pay. You owe nothing if your profits do not exceed the exclusion amount and you comply with the IRS requirements for claiming the exclusion. You will owe a 15% tax (based on the single filing status) on the gains if your profits are greater than the exclusion limit and you earn between $44,626 and $492,300 (2023 rate).
Do I Need to Tell the IRS About the Selling of My House?
If none of the following apply, you might not be obliged to disclose the sale of your home:
- You have taxable gain on the sale of your house that is non-excludable (less than $500,000 for married taxpayers filing jointly and less than $250,000 for single taxpayers).
- You received a Form 1099-S informing you of the real estate sale profits.
- Even if all or a portion of the gain is exempt, you still need to report it as taxable.
When you sell a second home, are there capital gains taxes due?
It is challenging to avoid capital gains taxes on the sale of a second house without changing that home to your principle residence since the IRS only permits exemptions from capital gains taxes on a principal residence. This entails following the two-out-of-five-year guideline (you lived in it for a total of two of the past five years). Simply put, you may demonstrate that you stayed in one place long enough to have it count as your primary residence.
It is not designed to be the exemption-eligible residence if one of the properties was bought largely as an investment.
The line separating investment property from vacation property is as follows: A property qualifies as investment property if the taxpayer has owned it for two full years, rented it out for at least 14 days each of the two prior years at a fair rental rate, and hasn’t used it for personal purposes for at least 14 days during the previous 12 months, whichever is greater.
It is likely to be regarded as personal property, not investment property, if you or your family live in the house for more than two weeks out of the year.
This makes it liable for capital gains taxes, just like any other asset save your primary dwelling.
When selling a home, do you have to pay capital gains taxes if you lose money?
Losses on a principal property are not deductible, and they cannot be used as capital losses for tax purposes. On investment or rental property, though, you might be permitted to do so.
Remember that losses on sales of other assets up to $3,000 or your total net loss may be used to offset profits from the sale of one asset, and these losses may be carried over to following tax years.
If you sell below market value to a friend or family, the IRS may see the transaction as a gift and tax the receiver on the difference. Additionally keep in mind that the receiver inherits your cost base in order to calculate any capital gains when they sell it, so they should be aware of the price you paid for it, the amount you spent improving it, and any selling-related expenses, if any.
Capital gains taxes can be very high. Thankfully, homeowners who fulfill specific IRS requirements might get some help under the Taxpayer Relief Act of 1997. Up to $250,000 of capital gains can be deducted for single taxpayers, and up to $500,000 of capital gains can be excluded for married taxpayers filing jointly. Capital gains rates are applied to gains that surpass certain limits.
There are guidelines for when sales must be disclosed, as well as exclusions for certain circumstances like divorce and military deployment. You may better prepare for the sale of your property by being aware of tax changes and keeping up with tax regulations. And if you’re searching for a new house, think about comparing the top mortgage rates before submitting a loan application.