Take Advantage of Tax-Free Capital Gains When Selling Your Home

The housing market is red-hot right now, thanks to continued low interest rates and plenty of demand. That’s understandable, as the world is opening back up and people have a much clearer idea of how they want to live their post-pandemic lives. 

It’s a seller’s market right now, and if a move makes sense for you — particularly if you’re downsizing — you could walk away with a tidy profit. But what would making a killing on a home sale do to your tax situation?

Your house is an investment, so selling it for a profit could leave you with a tax bill on the gains. Unlike selling stocks or bonds, however, there are important capital gains exemptions when you sell your primary residence. Here’s what you need to know.

What Are Capital Gains?

Capital gains are the profits you earn when you sell an investment for more than its purchase price. Your home is a major investment — probably the largest you will ever make — and selling often results in a profit, as real estate values historically tend to rise over time. Capital gains are also earned on other types of investments, including stocks, bonds, and occasionally property like a classic car or collectibles.

Capital gains are taxed by the IRS according to a specific set of rules. Short-term capital gains (profits on investments held for less than one year) are taxed at your ordinary income tax rate. Long-term capital gains are taxed at 0%, 15%, or 20%, depending on your income and whether you’re filing single or jointly. 

While those rates apply for most investments, the sale of your home is different, and you may qualify for a big tax break on those capital gains.

How Are Home Sales Taxed?

To give homeowners a break when they sell their largest investment, the IRS has carved out a significant capital gains exclusion when you sell your primary residence. Single filers may be exempt from paying capital gains taxes on the first $250,000 of profit from a home sale, while married filers may exclude up to $500,000 of profits.

For example, if you are a single person who bought your home for $200,000 and later sold it for $400,000, you made a profit of $200,000. That amount falls within the exclusion, so you would owe no tax on your profits.

This is a huge tax break for most people! If you’re married, you could enjoy a tax-free gains of up to $500,000 if your home has risen significantly in value.

How to Qualify for the Tax Exclusion

There are specific rules you have to follow in order to qualify for this big tax exclusion. To have all of the capital gains taxes forgiven, you must:

• Have owned the home for at least two of the last five years
• Have used the home as your primary residence for at least two of the last five years
• Not have claimed the capital gains exclusion on another property within the past two years
• Not have acquired the property through a 1031 exchange
• Not be subject to expatriation taxes

Note that you do not have to live in the home as your primary residence for two consecutive years. As long as you lived there for a total of two years out of the last five, even if only a few months at a time, you will pass the use test. There are also exceptions for members of the military or who hold certain other government jobs that force them to be deployed overseas.

What Happens If Your Profits Are Over the Limit?

If, when you sell your home, you end up earning more than the allowable amount, you’ll have to pay capital gains taxes on the difference. For example, a single filer who bought their home for $200,000 but sold it a decade later for $500,000 made a profit of $300,000. For a single filer, this is $50,000 over the $250,000 capital gains exclusion amount. That means that this filer must pay capital gains taxes on $50,000.

The amount you pay in capital gains taxes depends on your total income, which includes your salary plus your taxable capital gains. In 2021, if you earn less than $80,000 total, you pay 0% in capital gains taxes. 

If your total taxable income is between $80,000 and $441,450 for single filers or between $80,000 and $496,600 for married filers, you pay 15% in capital gains taxes. For filers over those limits, capital gains are taxed at 20%.

How to Reduce Your Capital Gains Exposure

If your home value has increased significantly since you bought it, you may still be able to make an adjustment to reduce the capital gains taxes you pay. If you made improvements to your home — i.e., remodeling, additions, or other major improvements like a new roof — you can add the cost of these investments to your cost basis.

For example, suppose our single filer who bought their home for $200,000 built an addition for $50,000 before selling the home for $500,000. This homeowner can add the $50,000 expense to the $200,000 cost basis for an adjusted basis of $250,000. That means their official profits are now only $250,000, which is within the limit and therefore tax free.

Even if you can’t wipe out all of your capital gains by offsetting home improvements, you may be able to reduce what you owe. The lesson? Save all those receipts! You’ll need good records or your improvements to successfully adjust your cost basis.

The Bottom Line

Selling your home can lead to a large capital gain — and one that’s largely tax free. As long as you’ve owned and lived in your home for two of the past five years and haven’t claimed another exclusion in that time, you can enjoy a major tax break. Keep track of all your expenditures on improvements to help make sure your profits stay within the limits, and you’ll likely avoid paying all or most of the capital gains taxes when you sell your biggest investment.