How to Avoid Taxes on Capital Gains When Selling Your House
Whether you’re selling an investment property, a home you inherited, or a home you’ve lived in when it’s time to upgrade, the goal is typically the same: you want to get as much money as you can from the sale of your home.
It may feel great to close on a high offer and get close to (or even right at) the amount you were asking for your home, but rarely will a homeowner get to keep all that money from the sale of a home.
I’m not talking about paying out commissions and closing costs, either.
The IRS may want to get a piece of the profit you made from selling your home. The tax that’s sometimes applied to your earnings from the sale of property is called Capital Gains tax, and it can take a chunk out of the money you’ve earned.
What is capital gains tax?
According to Investopedia, capital gains tax is defined as:
“Capital gains tax is a tax levied on capital gains, which are profits from the sale of specific types of assets, including stocks, bonds, precious metals and real estate. This tax is calculated on the profit – or positive difference – between the sale price and the original purchase price of the asset.”
How capital gains taxes work
Capital gains taxes aren’t paid on a regular cycle such as quarterly or annual taxes. Instead, capital gains taxes are only triggered when an asset (like your home) is sold. So, taxes of this nature are never paid while you hold a property whether it’s an investment property or your own residence.
No matter how long the property or investment is held, and no matter how the property appreciates over time, capital gains taxes would not be owed until it’s sold.
Exclusions for capital gains
The IRS does allow for exclusions when calculating capital gains.
- Single people can exclude $250,000 of capital gains on real estate sales
- Married couples (filing joint) can exclude $500,000 of capital gains on real estate sales
For example, If you purchase a home for $150,000 ten years ago and then you sell it for 600,000, you stand to make a substantial profit of $475,000 on the home. For a single person, $250k of that capital gain might not be subject to taxes but $225k may still be. For a married couple filing joint, the full amount might be excluded.
Filing status doesn’t guarantee exclusion
There’s no guarantee that you’ll get exclusions based on your marriage and filing status. There are a number of factors that can nullify these exclusions, including:
- The home you’re selling wasn’t your principle residence (you didn’t live there most of the time)
- You owned the property for under 2 years in the 5 year period before selling it
- Not living in the house for at least 2 years in the 5-year period before you sold the home
- You already claimed the exclusion on another home in the 2-year period before the sale of the home you’re trying to claim an exclusion on
- The home was “purchased” (acquired through a like-kind exchange) using a 1031 exchange within the last 5 years
- You’re required to pay an expatriate tax
How to avoid capital gains taxes
When looking at the factors that can eliminate your exclusion from capital gains it’s easy to see where the tax code offers generous provisions and a huge tax break for those who are selling their house.
In order to be eligible for the tax break you just need to make sure the home you’re trying to sell has been your primary residence, that you’ve owned it for at least 2 years, and you must have living in the house for at least 2 years of the last 5 years.
Unless you’re dealing with high value real estate the exclusion is substantial and makes it so that most single people and especially married couples selling a home are able to avoid any kind of capital gains tax.
The provisions are so substantial that a lot of real estate investors, including those who flip homes, have become adept at working the system in a way to ensure they earn tax free income.
The key point to pay attention to is that you must live in the house for at least 2 years in order to avoid a capital gains tax. In fact, the two years don’t even need to be consecutive as long as you meet the duration.
This has provided a break to many people ranging from military to foreign services, intelligence operators, and even the disabled.
While most homeowners selling their residence don’t have to worry about this and are generally guaranteed to get the exclusion, this kind of tax can create issues with family estates.
When family inherits property like a home, the value of the house gets a “stepped up” status. From the US Tax Code:
“Under Internal Revenue Code § 1014(a), when a person (the beneficiary) receives an asset from a giver (the benefactor) after the benefactor dies, the asset often receives a stepped-up basis, which is its market value at the time the benefactor dies. A stepped-up basis is often much higher than the before-death cost basis, which is primarily the benefactor’s purchase price for the asset. Because taxable capital-gain income is the selling price minus the basis, a high stepped-up basis can greatly reduce the beneficiary’s taxable capital-gain income when the beneficiary sells the inherited asset.”
If you’re in a position where you’ll be inheriting a home this can benefit you as the new property owner. Even if the home isn’t your primary residence and you have not lived there you may not have to pay capital gains taxes.
For example, a home you inherit has its value stepped up to $180,000. While the original purchase price of the home was only $90,000 and the home sells for the stepped-up value of $180,000 you won’t have to pay capital gains taxes. In this case, the tax is based on the difference between the sale price and the stepped up value as opposed to the original purchase price vs the sale price.
Homeowners can also reduce the capital gains tax by keeping track of home improvements.
Improvements are a natural part of owning a home as well as preparing it for sale. Even those who want to sell a home fast, such as those that come from inheritance, can be faced with necessary home improvements and upgrades before a home can be sold – such as updates to get a home up to code.
Any money you spend on home improvements, especially those that are costly (think replacing plumbing, foundation fixes, repairing or replacing the roof, flooring, etc.) can all be used to reduce capital gains tax.
Specifically, because the cost of those improvements gets added to the property’s basis (the original cost of the property, adjusted for factors such as depreciation).
For example, if you performed $20,000 in updates and renovations on your home before selling it, you would have a lower gain on the sale of the home and as such you would potentially have a lower capital gains tax – or none at all depending on your exclusion and the final sale price of the home.
Avoiding and reducing capital gains
Depending on the reason for selling your home you may be able to reduce and even eliminate capital gains taxes. You don’t necessarily have to go through the process of costly and time-consuming updates to your home just to adjust the property’s basis. It’s even possible to reduce and avoid capital gains tax when you need to sell your home fast.
Want to learn more about selling your home quickly and getting a fair cash offer? Contact W Properties today for more information at (405) 673-4901.