When you hear the term “capital gains tax,” you probably think of Wall Street investors and large stock portfolios. You probably don’t think about your modest four-bedroom house in the suburbs.
But capital gains taxes can be applied to the sale of virtually anything of value, including cars, equipment, and property. As long as there is a profit from the original purchase to the sale price, you have the potential for taxes.
This includes your home.
If there is the sale of property, there is the chance for capital gains taxes. But homeownership, which is seen as a pillar for American prosperity and financial stability, is treated with slightly different rules.
Selling Your Home and Capital Gains Tax: What All Homeowners Need to Know
Note: Tax Laws Change, Be Sure to Speak with a Qualified Tax Professional
Tax laws will change regularly and depend on local, state, and federal regulations. San Diego Purchase Loans is not a tax advisor; you must speak with a qualified professional before making any financial or tax-related decisions.
What are Capital Gains Taxes?
If you make a profit off the sale of a property or asset, it is considered a “capital gain.” This can apply to stocks and bonds, as well as physical items such as machinery or vehicles. The “gain” is usually the difference between what you sold it for and what you paid originally. For example, if you purchased $10,000 in company stock and sold it for $50,000 (certainly an excellent return), you would have a capital gain of $40,000.
Capital gains taxes are simply taxes on those gains. If you make a profit off a sale, it is considered part of your income and is therefore subject to taxation. However, it is not treated in the exact same manner as income, and there are exceptions to the tax, including profits realized after the sale of your primary home.
Sale of the Home: Usually Exempt from Capital Gains
If you sell your home, the first $250,000 ($500,000 for married couples filing jointly) is exempt from taxation. Assuming you have owned your home for the mandated period and meet all other requirements, the first $250,000 in profit is excluded from your tax bill. If, however, you make $300,000 in profit from the sale of the home, you will have to pay taxes on $50,000.
To qualify for this exemption, you have to have lived in the home for at least two years, and it must have been your main home for this time period.
You’ll Pay Higher Taxes if You Sell the Home Quickly
In general, if you purchase and sell a primary residence quickly, you will have to pay more taxes on your capital gains. This is because short-term capital gains, which are taxed like regular income, are treated differently than longterm capital gains.
Longterm capital gains give you the benefit of a reduced tax rate, which is usually less than 20%. So if you have held on to the property for at least a year, you have essentially reduced the tax rate. The taxes can be even less if you hold the property for longer, because it will allow the exemption to kick in.
Capital Gains Based on “Cost Basis,” Not Original Purchase Price
One thing to remember about capital gains in relationship to selling your home is that the taxes are based on the final sale price minus the “cost basis,” not the sale price minus the original purchase price.
For example, let’s say you purchased the home for $600,000 and spent $100,000 on maintenance and remodeling; this would make your cost basis $700,000. Five years later sold the home for $1 million. In this case, the capital gains would be $300,000. ($1,000,000 – $700,000 = $300,000). If it was only the original purchase price, and not the maintenance and remodeling, you would have a capital gain of $400,000. (Because the $100,000 in home remodeling was not included.) You can see that using cost basis instead of purchase price is beneficial.
Exemptions for Investment Properties
If you have investment properties, you may be able to exclude a portion of profits from your tax burden. Sections of the tax code allow you to avoid paying taxes on the initial profit if you are selling and then purchasing a similar property. For example, if you are selling your office space, then purchasing new office space, you may be able to exclude capital gains. There are details as far as the prices of one vs the other, so talk with a tax professional for more information on this situation.
Strategies for Reducing Capital Gains Taxes on the Sale of a Home
To avoid a heavy tax burden after the sale of a home, there are a few strategies you can adopt.
Don’t Sell the House Before Five Years
To avoid capital gains on the sale of your home, you need to be in the house for at least two years and have owned it for five. If needed, you may want to consider renting the property to reach five years of ownership.
Sell After Experiencing Capital Losses
If you are experiencing, or expect to experience, a loss in regular income over the next few years, it may be ideal to sell the home. Because you are experiencing a capital loss, you may be in a lower tax bracket, which could result in having less capital gains subject to taxes.
Keep Records of All Home Improvements
Because the capital gains from the sale of the home is based (basically) on your total costs, you should keep detailed records of all repairs, maintenance, and remodeling costs. These costs can be added to your total cost basis, which will decrease the official number that is considered your capital gain. Be sure to keep records so you can use these expenses to your advantage.
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