What Is Capital Gains Tax and How Your Home Sale Can Affect Your Taxes?
Homeowners pay a lot of taxes.
One is the capital gains tax. If you plan to sell your home, you may have to pay that tax.
To understand how the capital gain tax is levied on real estate transactions, you should find out how much it will cost you and why to make an informed decision on when it comes time to sell your home.
But did you know that you can get away from paying this tax liability?
Read on to understand what a capital gains tax is, guidelines to follow to qualify for an exemption, and the occasions when you’ll be subjected to pay the tax.
How the Capital Gains Tax Affects Your Home Sale
- The capital gains tax is a tax applied to any net gain from asset sales such as jewelry, stocks, and property.
- Your capital gain is considered short-term if you owned your home for less than a year. The net gain is taxed differently than a long-term capital gain.
- Your short-term capital gain from your home sale will be counted as part of your income on your taxes.
- A long-term capital gains tax applies only to homes owned for a year and over.
- The capital gains tax can be anywhere from 0%-20% depending on the amount of net gain from your home sale.
- You can claim some exemption from your capital gains tax if you've owned your home for at least 2 years and lived in it for at least 2 non-consecutive years out of the last 5 years as a primary residence.
What Is Capital Gains Tax?
As its name suggests, the capital gains tax is a tax on any gains you’ve made after you sell an asset such as bonds, jewelry, coin collections, or stocks.
In other words, you pay a tax when you sell something for more than you spent to buy it.
The capital gains tax is most known for how it affects a real estate transaction.
You pay the tax when you sell your primary home or a piece of property like your vacation home and make a profit.
The length of how long you’ve owned your home, your income, and your tax filing status determines your tax rate.
Depending on your particular situation, you may pay a capital gains tax rate of 0%-20%. And you don’t just pay the tax on property you sell.
You also pay when you make a profit by selling your boat or vehicle or any investments and stocks.
But you only pay the tax when you make a profit. You don’t pay it if you break even or sell below the cost you paid for a vehicle or boat.
What Are Short-Term Capital Gains and Long-Term Capital Gains?
Capital gain taxes apply according to how long you’ve held your home.
If you make a profit from selling your property that you’ve held for a year or less, this is a short-term capital gain.
If you make a profit from your property that you’ve kept longer than a year, this is what is called a long-term capital gain.
How Short-Term Capital Gains and Long-Term Capital Gains Affect You
The government considers these two types of capital gains differently and they are taxed by very different standards.
The Short-Term Tax Rate
Short-term capital gains taxes are assessed if you only own your home for less than a year. The taxes you pay will depend on your income.
The rate is equal to your ordinary income tax rate, which is known as your tax bracket.
The Long-Term Tax Rate
The long-term capital gains tax rate is lower than the short-term tax rate.
If you’ve owned the property for more than a year, you can benefit from a reduced tax rate on any profits you make from the sale of your home.
According to the IRS, homeowners in the lower tax bracket may pay nothing for their capital gains tax rate.
For those in higher brackets, they can save as much as 17% and pay either a 15% or 20% rate that depends not only on your income but also your filing status.
In most cases, you will pay less in taxes on long-term capital gains than you will on short-term capital gains.
How Do You Figure Out Your Tax Rate in Relation to Earned Income?
Single people qualify for the 0% capital gains rate if they have an income below $40,000.
If their income is between $40,001 and $441,500, they will fall into the 15% capital gains rate.
If a single person has an income of more than $441,500, that person will get hit with a 20% long-term capital gains rate.
For married couples with incomes of $80,000 or less will stay in the 0% bracket.
But if they earn between $80,001 and $496,600 they will have a capital gains rate of 15%.
Those with incomes above $496,600 will be hit with a 20% long-term capital gains rate.
Let’s break that down:
Your tax rate is 0% on long-term capital gains if you are single and earn less than $40,000 or married and earn less than $80,000 together.
Your tax rate is 15% on long-term capital gains if you are single and earn between $40,000 and $441,500 or married and earn between $80,001 and $486,600.
Your tax rate is 20% on long-term capital gains if you are single or married and earn more than $496,600. For those who earn above $496,600, the rate tops out at 20%.
These figures are provided by the IRS.
|Tax Rate||Filer's Income|
|20%||$441,451 and up|
|Tax Rate||Filer's Income|
|20%||$469,051 and up|
|Tax Rate||Filers' Income|
|20%||$496,601 and more|
|Tax Rate||Filers' Incomes|
|20%||$248,301 and more|
Can You Be Excluded from Paying the Capital Gains Tax?
You may be overwhelmed if you think you may have to pay a capital gains tax.
But there are many criteria you may qualify for to bypass the capital gains tax or lower it.
There are exclusions from being taxed when you sell your home. But different guidelines apply based on whether you are single or married.
If you’re single, the IRS allows you to exclude $250,000 of capital gains tax from taxable income.
This will remain in place no matter how much you make.
The capital gains from a primary residence can be excluded from your income permanently.
If you’re married and file jointly, the IRS allows you to exclude up to $500,00 of capital gains tax.
For example, if you purchased your home for $350,000 and three years later you sell it for $550,000, the capital gain would be $200,000. You won’t have to pay the capital gains tax since your profit is under the $250,000 limit.
But if you go above the limit, you’ll have to pay capital gains tax on anything above it.
For example, if you’re married and paid $600,000 for your home and then sell it for, say, $1.2 million, your profit is $600,000. Now since it’s above the $500,000 cap, you’ll have to pay $100,000 in taxes.
|Filing Status||Net Profit Exempt From Tax|
|Married, filing jointly||$500,000|
How Do You Qualify for an Exemption on Capital Gains Tax?
One of the most important situations for avoiding the capital gains tax is to make sure you meet the requirements of living in your home.
To claim the whole exclusion your home has to be your primary residence. A primary residence is the main home that you live in throughout the year.
To get the primary residence exclusion, there are three requirements you need to meet.
You Need to Have Owned Your Home For At Least Two Years.
You cannot claim an exclusion if you owned your primary residence for less than the last 24 months before your home sale.
If you've owned it for less, it's considered a short-term capital gain and is not eligible for an exclusion.
You Need to Have Lived in Your Home For At Least Two Years Out of The Last Five
The IRS states that you don’t have to occupy your primary residence in two consecutive years as long as it's any two out of the last five years.
You Didn't Claim an Exclusion For a Different Home Recently
The tax rate you pay on your capital gains depends in part on how long you hold the asset before selling.
The IRS only allows you to claim this exemption every two years.
So, if you sold another property in the last two years, which also qualified for a long-term capital gain exemption, you cannot make the claim for your most recent sale.
Remember to File For Your Exclusion For That Tax Year
Keep in mind that you have a limited time to sell your house from the day you move out to qualify for an exclusion.
Also, if you need to prove your home is your primary residence, you can provide documentation such as your tax return or your voter registration card.
Can You Qualify for the Capital Gains Tax Exemption If You Didn't Meet the Requirements?
You may still qualify for an exemption even if you only stayed in your principal residence for one year in the five years preceding the sale of your home.
This can occur if you become physically or mentally unable to care for yourself.
Or if your doctor recommends a change in residence for you because you were experiencing a health problem.
The time you spend at a care facility such as a nursing home or an in-patient treatment center counts toward your two-year residence requirement.
So too does providing medical or personal care to a family member suffering from a disease, illness or injury.
A family member includes your parent, grandmother, child, brother, sister, uncle, aunt, nephew, niece and more.
What Happens If You Have to Move from Your Primary Residence?
If you can’t meet the requirements for staying in your house because you have to move due to your job, you again may qualify for an exception.
You can reduce what you owe by taking a partial exclusion for capital gains tax.
Here are the requirements you need to meet.
One, if you took a new job or were transferred to a new job in a work location at least 50 miles farther from your home than your old work location.
Two, if you had no previous work location and you began a new job at least 50 miles from your home.
Three, either of the above is true of your spouse, a co-owner of the home, or anyone else for whom the home was his or her residence.
What Other Ways Can You Be Exempt from Capital Gains Tax?
If any of the following events occurred during the time you owned your property and lived in the home you sold, you might be eligible for an exemption.
Your home was destroyed or condemned because of a natural or man-made disaster.
You can no longer maintain your home because you begin to experience significant financial difficulty, such as a loss of a job.
Your home becomes less suitable as a main home for you and your family for a specific reason, such as your home is too crowded to live comfortably.
Anyone who lives in your home like your spouse or co-owner dies, becomes divorced, or becomes unable to pay living expenses for the household because of a change in employment status.
Can You Be Disqualified from an Exemption?
Your $250,000 or $500,000 exclusion is very generous and helpful when you sell your home. But you will have to pay the entire tax if any of the following are true:
- The house wasn’t your principal residence.
- You owned the property for less than two years in the five-year period before you sold it.
- You didn’t live in the house for at least two years in the five-year period before you sold it.
- You already claimed the $250,000 or $500,000 exclusion on another home in the two-year period before the sale of your primary residence.
Can You Deduct Expenses from the Capital Gain of Your Home Sale?
Yes, you can reduce your capital gains tax liability if you deduct selling expenses from your home sales profit.
Selling expenses to deduct include your real estate broker’s commission, attorney fees, appraisal fees, closing costs, escrow fees, notary fees, and title search fees, for example.
However, note that all expenses related to your home are not permissible to be deducted from your net gain.
|Expense||Is it Deductible?|
|Real Estate Agent/Broker's Commission||Yes|
|Monetary Concessions to the Buyer||Yes|
|Mortgage Satisfaction Fees||Yes|
|Lien or Title Cloud Removal||Yes|
|Title Search Fees||Yes|
|Homeowners Insurance Premiums||No|
|Property Taxes Paid During Years of Ownership||No|
Can You Deduct Your Home Improvement Costs from Your Capital Gain?
You can also significantly reduce capital gains susceptible to capital gains tax by adding the amount of money you spent on capital improvements on your property.
Eligible home improvements include replacing the roof, building a deck, adding new bedrooms, replacing the flooring, or finishing a basement.
Keep in mind that home improvements do not include ordinary repairs and maintenance on your house.
And note that the higher your adjusted cost basis, the lower your capital gain when you sell the home.
For example, you purchase your primary residence for $200,000 and sell it for $550,000.
While living there, you spent $100,000 on finishing your basement and adding a new bathroom.
Instead of owing capital gains taxes on the $350,000 profit from the sale, you would owe taxes on $250,000. I
n that case, you'd meet the requirements for a capital gains tax exclusion and owe nothing.
|Expense||Is it deductible?|
|Installation/replacement of flooring/carpeting||Yes|
|New roof, windows, or doors||Yes|
|New fencings, retaining walls, decks, patios||Yes|
|Replacement of walkways and driveways||Yes|
|New ductwork, pipes, insulation||Yes|
|New Heating/Cooling systems||Yes|
|Major landscaping such as the installation of new lawns||Yes|
|Installing built-in appliances||Yes|
|Hiring a gardener for upkeep||No|
|New freestanding appliances||No|
|Hiring a plumber for repairs||No|