Will I Have to Pay Capital Gains Tax on the Sale of My Home?
If you sell an asset such as stock and you make a profit, you have a capital gain. If you're like most people, then your home is your largest asset. If you sell it for more than you paid, that's another type of capital gain.
It's a general rule that home sales are subject to capital gains tax, just like other assets. Most capital gains are taxed; however, there are several exceptions and exclusions. Depending on the circumstances, there might be a low capital gains tax or even none at all. A thorough understanding of capital gains taxes will help you maximize your earnings when you sell your home. Read on to learn whether or not you'll owe money for capital gains tax during your home sale.
How to Calculate Capital Gains on the Sale of a Home
First, it's important to determine the amount of your capital gain. In short, your capital gain is the difference between your cost basis and your sale proceeds. Cost basis and sale proceeds are not necessarily the dollar amount you sold it for minus the amount you originally paid. The definitions of those terms below will provide a more precise calculation of your earnings.
Sales proceeds are the amount of how much you actually pocketed after you sold the house and paid expenses. If you sold your home for $1 million and paid $50,000 in commission and closing costs, your sales proceeds would be $950,000.
The cost basis includes the cost of the home and what you spent on improving it over the years. If you paid $200,000 plus $5,000 in closing costs, then later spent $95,000 to upgrade the kitchen, renovate the bathrooms, and add a porch, then your cost basis is $300,000.
In this example, your capital gain is the sales proceeds ($950,000) minus the cost basis ($300,000), which comes to $650,000.
What Is Home Sale Capital Gain Exclusion?
In the above example, you wouldn't necessarily have to pay capital gains tax on the entire $650,000, thanks to something called the home sale gain exclusion or the primary residence exclusion.
If the house was your primary residence, you might be able to exclude $250,000 of capital gains if you're a single taxpayer or $500,000 if you file jointly.
You must meet a few requirements to be eligible for this exclusion.
- You must have owned the property for two of the five years before the sale of the home.
- You must have lived in the house for two of the five years before the sale, although they don't have to be the same two years.
- If you previously claimed the exclusion on another home, two years must pass before you may claim it again.
Even if you don't meet the criteria, you may be able to claim part or all of the exclusions if you were forced to sell for reasons of change in work, health complications, or an unforeseeable event.
You won't be able to claim the exclusion for a house you rent out or a vacation home unless you actually lived there two of the five years.
In our example, a joint filer eligible for the exclusion would have a taxable capital gain of $150,000 ($650,000 - $500,000), whereas a single taxpayer would have a taxable gain of $400,000 ($650,000-$250,000).
How Much Capital Gains Tax Do I Owe After Exclusions?
The IRS offers different tax rates for long-term and short-term capital gains. But how do you know if your home is a short-term or long-term gain? If you had the home for less than a year, it's considered a short-term capital gain, and you must pay tax according to your bracket, the same way you do on earned income. To be considered a long-term gain, you must have owned the home for longer than one year.
In our example, the $150,000 is a long-term gain with a tax rate of 0%, 15%, or 20%, depending on reported taxable income. If the income is less than $40,000 for a single filer or $80,000 for a joint filer, no capital gains tax is required.
Don't forget that you may have to pay state or local taxes depending on your situation and where you live.
Should you decide to leave the home to an heir instead of selling, the heir would be exempt from capital gains tax because taxes are not required for gains that took place outside of a person's lifetime.
The Importance of Understanding Home Capital Gains Tax
The IRS offers a significant tax concession to people who sell a primary residence. It's important to know what the rules are and what breaks you qualify for. Understanding the rules and exemptions of capital gains tax will help you reap the full financial benefits of homeownership.