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Selling your old house and downsizing for retirement is a common practice for people entering their golden years. Although the gain from the sale of a home is considered a capital gain, the IRS usually allows you to exclude some (if not all) of the gain from your taxes.
But what if you sold your house and pocketed as much as $640,000? You could still owe hefty capital gains taxes on the sale, depending on whether you’re married or not. On the other hand, you may still be able to avoid taxes by using other investment losses to offset your gains or deferring taxes with a similar exchange. But if you need extra help managing your capital gains tax bill, consider talking to a financial advisor.
When an investment increases in value and is sold for more than the original purchase price, the gain is taxed. This applies to assets such as stocks, bonds, collectibles, and real estate, including your personal home.
For assets held for more than one year, the IRS applies long-term capital gains rates of 0%, 15%, or 20%. The precise capital gains tax that will apply depends on the taxpayer’s income, but capital gains taxes are generally lower than ordinary income tax rates. Many US states also tax capital gains and impose rates that they use on ordinary income.
However, profits from the sale of personal homes are treated differently. You can exclude the benefit from tax in whole or in part if you have lived in the home for at least two years (cumulatively) over the past five years. And when you’re getting ready to make a big financial decision, like selling your home to downsize, discuss it with a financial advisor who can help you understand how the move will impact your larger financial plan.
If you receive $640,000 net from the sale of your old home, your capital gains tax bill will depend on a number of factors:
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Archive status. This affects how much of the profit you can exclude. If you are married and filing jointly, you can exclude up to $500,000 in gain from the home sale. This would leave $140,000 of the $640,000 subject to taxes. If you file as an individual, you can exclude up to $250,000. In this case, $390,000 would be subject to taxes.
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Income. The capital gains tax rates for most people are 0%, 15% and 20% based on their income.
Assuming you pay 15% on the capital gains, you will owe $21,000 ($140,000*0.15) in federal taxes after applying the exclusion if you are married and filing jointly. If your filing status is single, you will owe $58,500 in capital gains taxes ($390,000*0.15). But remember, a financial advisor can help you plan for capital gains taxes and find ways to potentially mitigate them.
You have limited options to avoid capital gains taxes after applying the principal residence exclusion. However, there are some available techniques, including:
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Accurately calculate your cost basis. The cost basis is the purchase price of your home plus any improvements. You subtract the cost basis from the amount you sell the property to get the taxable profit. Including the cost of adding a room or other improvement to your cost base could significantly reduce your taxable profit.
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Offset investment gains with losses. You can reduce taxable capital gains by harvesting investment losses. For example, if you sell a stock for $40,000 less than what you paid for it, the loss will offset $40,000 of your profit on the sale of your house. In that case, you reduce the taxable gain on the sale of your house from €21,000 to €15,000 (assuming you are married and filing jointly).
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Using a like exchange. Using a technique called a 1031 exchange, you may be able to use the entire proceeds from your home sale to purchase another home without having to immediately pay taxes on the gain. Although tax rules limit 1031 exchanges to investment properties, you may be able to exchange your home if you move and rent it to someone else for at least two years. This turns it into an investment property in the eyes of the IRS. At that point you can make a similar exchange for another property. After renting out this new property for about a year, you may be able to move in and use it as your personal home.
And if you need advice about a 1031 exchange or the other strategies mentioned here, consider talking to a financial advisor.
These techniques can only be used in certain situations. For example, if you have inherited the home, special rules may apply. Other restrictions may also apply, including:
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You may only be able to avoid taxes on part of your profits. Unless your gain is less than the allowable exclusion or you have sufficient offsetting losses, some of your gain may still be taxable.
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A similar exchange only delays taxesWhen you eventually sell the property you traded for, that sale will incur taxes.
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Not all properties qualify for exclusion. The capital gains exclusion for primary residences does not apply to vacation homes or investment properties.
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There are residency period conditions. If you have lived in the home for less than two years in the past five years, you cannot use the exclusion. You may be required to provide tax returns, utility bills and other documentation to prove that you have lived there for the required time.
Homeowners who meet IRS requirements can exclude from taxes up to $500,000 in gain from the sale of their primary home ($250,000 if they are single). However, a gain that exceeds the IRS exclusion limits will be subject to long-term capital gains taxes if the home was owned for more than one year. In that scenario, you could use tax loss harvesting to offset some of the gains and reduce your tax bill, or a similar exchange to defer taxes until a later date.
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Develop a strategy to protect the profits from selling your home from taxes by consulting a financial planner. 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 how much tax you might owe on the sale of assets such as stocks and real estate.
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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 is not 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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The post I am selling my house and receiving $640,000 to save for retirement. How can I avoid capital gains taxes? first appeared on SmartReads by SmartAsset.
