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There’s a lot of pride associated with owning a property, whether it’s a primary home or a vacation bungalow. It’s especially rewarding if your home fetches a high price when you sell it. While a high selling price may be exciting at the moment, it typically comes with a potential drawback. As a capital asset, any gains you make on the sale of your real estate can trigger tax consequences. A financial advisor can also help you create a financial plan for your real estate needs and goals.
What Are Capital Gains Taxes?
From personal items to investment products, almost all of your possessions are capital assets. When you sell one of these assets, such as your home, any profit you make from that sale can incur a tax called a capital gains tax.
Long-term capital gains occur when you sell an asset that you’ve held for more than one calendar year. Short-term capital gains, on the other hand, apply when assets are held for less than a year.
While tax rates vary, long-term capital gains are typically taxed at a lower rate than short-term capital gains. Long-term capital gains tax rate varies between 0%, 15% and 20%, with the rates based on your income level. There are a few higher rates for particular items, but they don’t apply to a home sale. In contrast, short-term capital gains are taxed as normal income, which can be a much higher rate. Income tax rates vary between 10% and 37%.
When Do You Have to Pay Capital Gains Taxes?
Capital gains taxes only kick in for realized gains. That means it applies only when you sell an asset for more than its cost basis, or the amount of money you’ve put into the property, otherwise known as your capital investment. If a gain was unrealized, meaning it’s value has increased while you still own the item, then capital gains tax would not come into play.
So, if you make a profit off the sale of your property, you might have to pay capital gains tax. Let’s say you purchased a property six years ago for $200,000 and recently sold it for $300,000, resulting in a profit of $100,000. In this case, you would have to report the sale and possibly pay a capital gains tax on the profit. One caveat, though: The IRS offers a tax exclusion if the property is your primary residence. Under this provision, you can exclude up to $250,000 of your gain from your income (up to $500,000 if you file a joint return).
However, to claim this exclusion, you need to prove you owned and lived in the property for at least two years of the previous five years. Those two years do not need to be consecutive.
Capital Gains Taxes on Second Homes and Investment Properties
While the IRS offers generous capital gains exclusions on primary residences, the rules change when the property is a second home, vacation property or rental real estate. These types of properties do not qualify for the exclusion unless they meet strict ownership and use criteria.
For second homes or vacation properties that were never used as a primary residence, the full gain from the sale is typically subject to capital gains tax. The holding period still matters, though: Gains on properties held more than a year qualify for long-term capital gains tax rates, while shorter holding periods trigger higher ordinary income rates.
In the case of rental properties, additional factors come into play. Any depreciation claimed during ownership must be recaptured at the time of sale. This depreciation recapture is taxed at a higher rate—up to 25%—and reduces your cost basis, which can increase the taxable gain.
If you convert a rental into a primary residence or vice versa, the calculation becomes more complex. The IRS may allow a partial exclusion if you lived in the home for at least two of the five years before the sale, but the excluded portion may be prorated based on non-qualified use.
Recordkeeping is especially important for investment properties. Owners should maintain thorough documentation of all capital improvements, depreciation schedules and transaction records, as these will all affect the gain calculation and reporting requirements.
Consulting IRS publications or a tax professional is recommended when selling non-primary real estate, since eligibility rules, depreciation recapture and capital gains treatment may significantly impact your total tax liability.
How Much Capital Gains Tax Do You Have to Pay on a Home Sale?
The exact amount of capital gains tax you’d pay on a home sale would depend on your adjusted gross income (AGI), filing status and length of ownership. Your tax basis is also a major determinant. For a home sale, the tax basis depends on how you came to own your home. Here are two possible scenarios:
- You bought your home. In this scenario, the cost basis begins with the purchase price and includes specific closing costs. If you paid any taxes intended for the seller, those are added to the cost basis as well. Remodeling and construction expenses that increase the property’s value or longevity also contribute to the cost basis.
- You inherited your home. Here, the cost basis begins with the home’s value at the time of the previous owner’s passing. This is what’s known as a step-up in basis. In this scenario, you don’t have to account for capital gains taxes dating all the way back to the property’s purchase.
How to Avoid Capital Gains Taxes When Selling a House
If you want to make a profit from the sale of your house, you will owe capital gains taxes. However, there are some legal methods to minimize capital gains taxes, such as:
- Follow the 2-out-of-5-year rule: You must have used the home as your primary residence for at least two of the previous five years. You don’t have to live in the house for two years consecutively, just cumulatively, to qualify for the capital gains tax exclusion. Just those two years typically allow you to meet the use and ownership tests, which can allow you to qualify for an exclusion of up to $250,000 as an individual or $500,000 as a joint filer.
- Qualify for a partial exclusion: According to IRS Publication 523, certain situations may make you eligible for an exclusion of gain. If you sold the home because of work, your health or an “unforeseeable event,” you may be able to exclude some of your taxable gains.
- Hold on to home improvement receipts: Remember, as we discussed above, the cost basis of your property involves more than just its purchase price. It also includes any capital improvements you made. The higher your cost basis is, the lower your potential exposure to capital gains tax.
Bottom Line
Everyone wants to make a profit when they sell their home. However, there are expenses to account for, including the capital gains tax. A short-term gains tax will likely result in a higher tax rate, however. This means it’s often worthwhile to hold on to a property for more than one year to qualify for the long-term gains tax. But keep in mind that rules vary. Different types of properties may also result in changes to your potential taxes, so make sure you’ve done your research before making a decision, and review some of the potential ways to help avoid capital gains taxes when selling a house.
Tips for How to Avoid Capital Gains Taxes When Selling a House
- Navigating the ins and outs of capital gains taxes can be challenging. If you want to understand your tax responsibility while selling your home, seek professional guidance. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- At one point or another, you’ll face capital gains taxes. But that doesn’t mean you can’t find other areas in your life to cut back costs. If you’re an investor looking to minimize expenses, consider checking out online brokerages. They often offer low investment fees, helping you maximize your profit.
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