4 Things to Know About Capital Gains Tax Before Selling Your Home
For many people, selling a home is a great way to yield a tidy profit. The IRS generally taxes profits, also referred to as capital gains, although it depends on the type and the amount. As such, it is normal for sellers to wonder if they will have to pay capital gains tax on their home sale. While there is a method to exclude some or all gains, not everyone qualifies for the total amount. If you're planning on selling your home, it's imperative to understand the ins and outs of capital gains tax in order to limit your tax liability and keep as much of the profits as possible.
What Counts as Capital Gains?
The most basic definition of capital gains is the difference between the original purchase price and the sale price. If a homeowner buys a home for $300,000 and sells it for $400,000 five years later, the capital gain is $100,000.
The adjusted cost basis is the total amount a seller can exclude from a home sale to determine capital gain tax liability. The adjusted cost basis is the amount paid for the home plus other expenses the homeowner incurred to buy and improve the home. Keep in mind that this figure does not consider other deductions sellers might make the year they sell the home or the tax exclusions available when selling a primary residence.
Can Sellers Exclude Capital Gains From Their Tax Liability?
People who are selling a primary residence may be able to exclude some or all capital gains from their tax liability. The IRS allows exclusion of up to $250,000 for single filers and up to $500,000 for those married or filing jointly.
There will be a tax liability for all sellers who don't use the home as a primary residence, but sellers who bought the property as a primary residence and turned it into a rental property can still qualify for the exclusion as long as they resided in the home for at least two years during ownership. Capital gains on properties sold within a year of purchase are taxed like regular income, as is usually the case with fix-and-flip investors, while long-term capital gains have a tax rate of 15–20%.
How Can Sellers Qualify for the Exclusion?
As a general rule, sellers who lived in the home as a primary residence for two out of the past five years will be able to claim the exemption. The IRS allows sellers to meet this two-part requirement separately within five years of the sale. For example, if a person buys an investment property, converts it into a primary residence two years later, and then sells it three years after that, they may qualify for the complete exclusion.
There are a couple of reasons sellers might not qualify for the full exclusion, even if the property is a primary residence. Selling the home less than two years after claiming an exclusion for another property and not using the home as a primary residence for two of the most recent five years are two examples. Sellers might qualify for partial exclusions depending on the reasons for the move. For instance, special considerations are given for military personnel and those moving for health reasons.
Is It Possible to Change the Capital Gains Before Selling?
Sellers facing tax liability for capital gains should consider adjusting the cost basis, which would lower the total capital gains. The adjusted cost basis is essentially the amount of money you put into the home, including the purchase price. There are a few ways that sellers can change the basis, but the most common one is through capital improvements, such as:
- Roof replacement
- Siding upgrades
- Home additions
- Kitchen and bathroom renovations
Regular home improvement costs usually increase the cost basis if they are still part of the property at the time of sale. Generally, improvements paid by insurance as part of a claim do not increase the basis.
Navigating the Capital Gains Tax
Planning for capital gains tax is something that all sellers should consider, especially if they do not qualify for the exclusion. By educating themselves and following these rules, sellers can maximize the take-home proceeds from their home sale.