BIG IDEA: Learn how to avoid paying costly capital gains taxes when you sell your home!
Avoiding IRS requirements to pay capital gains taxes when selling your home can be tricky under some circumstances.
If you are selling a median cost home, things are usually relatively straightforward when avoiding capital gains taxes. However, the sale of higher-profile homes can easily lead to paying a great deal in taxes on capital gains—if you don’t handle your finances just right.
The five years before the sale of your property will be critical in calculating the taxes you will owe at the time of sale of your house.
- If you’re single, you can qualify for an exemption of $250,000.
- If you are married, you could be eligible for an exemption of $500,000.
- Additionally, anything you put into the property can be counted into your home’s base price.
Your home’s base price will be subtracted from your net investment income before taxes are calculated.
Why Are the 5 Years Before Sale Important?
To be eligible for the tax-free exclusion, there are a few simple-but-firm stipulations that you must meet.
If you meet all of the requirements within the five-year period before sale, you’ll have a good chance of selling your home without paying capital gains taxes.
- You can only qualify for the tax-free exclusion on the sale of your home if you have not already qualified for (and used) the benefit in the two years previous to the sale. In other words, if you’re flipping houses left and right, you won’t qualify for tax-free exclusions.
- Of the five years previous to the sale of your home, you must have owned the home asset for a minimum of two years. Ownership does not have to be maintained consistently over this period, as long as the total number of days you retained ownership of the house is equal to 730 days or more.
- To clarify, these two years of ownership can occur at any time during the five-year – or 1825 day – period.
- The home you are selling must also have been considered your primary residence for a minimum of two years, or 730 days, of the five years, or 1825 days, before the home sale.
- You must have purchased outright the property you are selling. It can not be an investment property swap, such as 1031.
- You must retain citizenship/residency in the US; otherwise, your assets are at risk of expatriation taxation.
If You’ve Owned 1 Year or Less
If you’ve owned your home for one year (365 days) or less, capital gains rates are much harsher.
These harsher rates are what the IRS dubs short-term capital gains taxes. This tax rate typically only applies to short-term investors and house flipping experts.
If the sale of your home falls under short-term capital gains tax rates, you will pay taxes on the property at a rate equal to your regular tax rate on income. Below is the current tax bracket information as listed by the IRS site.
- 37% for singles with an income of more than $523,600 and $628,300 for married couples filing jointly
- 35%, for singles with an income of more than $209,425 and $418,850 for married couples filing jointly
- 32% for singles with an income of more than $164,925 and $329,850 for married couples filing jointly
- 24% for singles with an income of more than $86,375 and $172,750 for married couples filing jointly
- 22% for singles with an income of more than $40,525 or $81,050 for married couples filing jointly
- 12% for singles with an income of more than $9,950and more than $19,900 for married couples filing jointly
- 10% for singles with an income of $9950 or less; and $19,900 for married couples filing jointly
How Can Short-Term Owners Avoid Capital Gains Taxes?
The bad news is…you can’t entirely avoid capital gains taxes on a short-term homeowner sale. However, the good news is that you can still avoid paying the capital gains tax on some of your home sale profits. It just takes a bit more effort on your part.
Let’s say, for instance, that you purchased a home last year at a closing cost of $125,000, with intentions of gutting and remodeling it in under a year.
That puts your home’s base value at $125,000. With the inflation in housing prices this year, you are selling the house in question for $300,000.
If you have kept track of your records properly throughout the process of the remodel, you can add the amount you’ve spent on the property since purchase to your property base value.
Every cent you put into the property (that you can prove with records) will reduce the profit that you will pay taxes for capital gains.
A typical gut and remodel of a lower square footage (1,000 sq ft or less) home costs between $100,000 and $200,000.
For the sake of our example, let’s say you spent $150,000. That increases your home’s base value to a total of $275,000 and lowers your taxable capital gains to just $25,000!
While this sample might not sound ideal, it can be a huge relief for many people who jumped into the real estate investment game in recent years.
If You’ve Owned 2 Years or More
If you’ve owned your home for two or more years, avoiding capital gains tax becomes much more feasible.
Obviously, you must still meet the stipulations discussed earlier regarding use, ownership, and other exemptions in the past two years.
However, the majority of homeowners interested in selling fall into this category and have little to no problems with achieving a 0% tax rate on their sales.
This is in part due to the current median home sale price, which is $350,000. However, to achieve the 0% tax rate on higher-profile homes, there are some (completely legal) tricks you will need to employ.
- You must get the 1099S or closing disclosure from the home’s initial purchase to establish your initial base value.
- You must keep all financial records about the property while owning the home you wish to sell. It can be increasingly challenging to keep these records over time, as things tend to be misplaced, forgotten, etc., but it is very important.
- The amount invested over time will be added to your property’s base value, dramatically lowering the capital gains percentage for which you will be responsible for paying taxes.
- Reduce your W2 and 1099MISC income as much as possible for the entirety of the year you are selling your home. This one trick may seem counterintuitive but will save you thousands of dollars when filing taxes for your adjusted gross income for the year.
How Reducing Your Earnings Decreases Your Home Sale Taxes
When you prepare to file your taxes for the year that you sell your home, you will pay taxes on your modified adjusted gross income, which includes the sale price of your home.
The problem is that once your gross income hits a certain level (refer to tax bracket table above), you actually pay more taxes on each additional dollar earned.
Let’s say, for instance, you are single, and your income threshold is $200,000. During the year, you bring home $120,000. You’re selling your home for $350,000.
With just these figures (no adjustments to base price), you would have a modified adjusted gross income of $470,000.
Meaning, you would have to pay an additional 3.8% net investment income tax on the $270,000 over your income threshold. That’s in addition to the regular, tax bracket-based tax you would owe on the $200,000 within your income threshold.
Some Final Advice on Avoiding Capital Gains Taxes
Even if you don’t qualify for tax exemption on your capital gains based on the criteria above, there may still be hope for you yet!
There are a few more options that qualify for some if not all exemptions on your capital gains.
If you can reasonably prove (as outlined by the IRS under Partial Exclusions) that you have to move due to an issue related to work or health, you can qualify for a partial exclusion on your capital gains tax.
The same is true of unforeseeable events, such as the death of a spouse, unemployment, divorce, or the birth of multiple children.
Military personnel on active duty may also be eligible for exclusions outside of normal conditions.
Our very last suggestion on avoiding capital gains taxes when selling a home is to look into the 1031 Exchange. Also known as an exchange of like-property, the 1031 requires you to identify 3 possible properties for purchase within 45 days.
You then have to purchase another “like” property within 180 days of the sale of your home. It does, however, defer capital gains tax for you indefinitely.
If your main priorities are to avoid capital gains tax while relocating, a 1031 could work perfectly.
Once you’ve completed the 1031 exchange, you will need to wait 5 years before selling to avoid capital gains tax on that property.
You still stand to make a profit in this manner, but it takes much longer.
Image by Gregory Butler