A net profit on a home sale of €680,000 could potentially result in capital gains tax being payable. But in many cases you don’t have to pay tax on the full amount of the winnings. And maybe you can protect it all. This is because of an exclusion that protects against taxation of up to $500,000 in gain when you sell your primary home. The exact amount you can exclude depends on the circumstances. And there are steps you may be able to take to reduce, defer, or even eliminate taxes on the sale of a home. Capital gains taxes are sensitive to your specific situation, so consider consulting a financial advisor about your course of action.
Capital gains on home sales
Every time you sell an asset for more than you paid, you generate capital gain. The tax authorities consider this profit as taxable. This applies to a gain on the sale of assets, including securities and real estate investments. However, due to the Section 121 Exclusion – named after a section of the tax code – up to $500,000 of the gain on the sale of a personal residence can be excluded from taxation.
How much you can protect against taxes can vary. For starters, the $500,000 exemption is only available to taxpayers who are married and filing tax returns jointly. If you file individually, you can exclude up to $250,000 from your winnings.
You may not be able to get an exclusion at all if you have not lived in the home for at least two years in the past five years. The years do not have to be consecutive, but the time you have lived in the home must total at least two full years out of the previous five.
If you lived in the home for a shorter period, the entire gain would be taxable. And it’s only for a primary residence. Holiday homes, second homes and investment properties are not eligible.
In addition, it must have been at least two years since you last claimed the 121 exclusion. You can do this as often as you like, up to your lifetime exclusion limit, but no more than every two years. Before 1997, there was a one-time lifetime exclusion of up to $125,000 for homeowners age 55 or older. The Taxpayer Relief Act of 1997 made a number of changes, including eliminating the one-time lifetime exclusion and the age requirement.
A financial advisor can help you stay abreast of changes in tax laws and strategize accordingly.
Capital Gains Tax Rates
The specific tax you may owe may also vary. A gain by a seller who has owned the home for less than a year is considered a short-term capital gain. This is treated as ordinary income, with the tax using regular federal income tax brackets that go up to a top marginal rate of 37%.
On the other hand, if the seller has owned the property for at least one year, the long-term capital gains tax rates apply. These are generally lower than ordinary income rates, ranging from zero to a maximum of 20%.
An example of capital gains
A married couple who made $680,000 from the sale of their primary residence after living in the home for at least two of the previous five years would normally be able to exclude $500,000 of the gain, assuming they have not previously used the exclusion under Article 121. This means that $180,000 may be subject to taxes.
If they had a combined income of $100,000, they would normally fall into the 22% marginal income tax bracket and owe federal income taxes of $14,261. After selling their home, the $180,000 in unexcluded gain on the sale of their home would be subject to capital gains taxes.
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The applicable capital gains tax rate may vary. It depends on whether the seller has owned the property for at least one year before the sale and also on the seller’s income tax bracket. For a seller who has not owned the property for at least one year, the gain is normally taxed as ordinary income, in this case at the income tax rate of 22%.
For a sale where the property was owned for more than a year, the preferential capital gains rates of 0%, 15% or 20% would apply, instead of the regular income tax rates. Your capital gains tax rate also depends on your income.
This couple with an income of $100,000 and a taxable gain of $180,000 after the $500,000 exclusion would pay tax on the gain at a rate of 15%. This would mean a capital gains tax of $180,000 times 15% or about $27,000.
A financial advisor can help you determine whether you will owe taxes on the sale of your home, depending on your specific circumstances. Match with a financial advisor.
Other strategies
If it appears that you may owe capital gains taxes on part of the sale of your home, you may be able to adjust the cost basis of the home by deducting the cost of certain improvements from the sales price. This reduces the amount of profit and the resulting tax. For example, if you spent $20,000 to replace a roof and $40,000 to add a bathroom, you might be able to increase cost basis by $60,000 and reduce taxable profit by a similar amount.
Another method to consider is a like-for-like exchange, or a 1031 exchange, after another tax code section. To do this, you essentially trade one investment property for a cheaper property. If done right, you won’t owe taxes on the price difference between the two properties until you sell the cheaper house.
However, similar exchanges are not possible with a primary residence. This only concerns real estate investments. To comply with the restrictions, you would have to convert your home into an investment property before selling it by renting it out for at least two years. Then you must rent out the purchased property for the same period after the sale. Only then could it be used as the retiree’s main residence.
Tax loss harvesting can also be helpful in lowering your tax bill. This works by applying a loss on the sale of another asset to reduce the capital gain on the sale of your home. Suppose you sold stock at a loss of $60,000. By applying this loss on a stock transaction to the gain on your home sale, you can reduce the capital gain on the home transaction. There are specific rules in place, so it may be wise to talk to a fiduciary financial advisor about your strategy.
In short
You can often shield all or part of the profit from taxes when selling a house. To take advantage of this, you must have lived in the home for two years before the sale. You can earn $250,000 if you are a single filer and $500,000 if you file jointly. If your gain is greater, or if you cannot exclude any gain at all, the tax depends on how long you have owned the home. The gain will likely be taxed as ordinary income if you owned it for less than a year. For a home that has been owned for a longer period of time, the lower long-term added value is used.
Tips
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A financial advisor can help you determine your likely tax liability when selling your home. Finding a financial advisor does not have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisors for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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Use SmartAsset’s capital gains tax calculator to estimate capital gains taxes when you sell a home, investment property or other asset.
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Have an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that isn’t at risk of significant fluctuations like the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But with a high-interest account, you can earn compound interest. Compare savings accounts from these banks.
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