What Is Capital Gains Tax and How Your Home Sale Can Affect Your Taxes?

As a homeowner, taxes can be a huge burden, particularly capital gains tax. If you're planning to sell your house, it's critical to understand how this levy is assessed on real estate transactions.

Knowing how much you'll be paying and why is essential in making an informed decision. But did you know there's a way to avoid paying this tax legally? Keep reading to discover what capital gains tax entails, the eligibility criteria for an exemption, and the circumstances under which you'll be obligated to pay it.

How the Capital Gains Tax Affects Your Home Sale

The capital gains tax applies 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 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 two years and lived in it for at least two non-consecutive years out of the last five 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 determine your tax rate.

You may pay a capital gains tax rate of 0%-20%, depending on your situation. And you don’t just pay the tax on the property you sell.

You also pay when you 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 profit from selling your property that you’ve held for a year or less, this is a short-term capital gain.

If you profit from your property that you’ve kept for longer than a year, this is 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 have very different taxation standards.

The Short-Term Tax Rate

Short-term capital gains taxes are assessed if you have owned your home for less than a year. The taxes you pay will depend on your income.

The rate equals your ordinary income tax, whichis 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 over a year, you can benefit from a reduced tax rate on any profits you make from selling your home.

According to the IRS, homeowners in the lower tax bracket may pay nothing for their capital gains tax rate.

Those in higher brackets 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 taxes on long-term capital gains than on short-term capital gains.

How Do You Figure Out Your Tax Rate About Earned Income?

Single people qualify for the 0% capital gains rate with 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.

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%.

The IRS provides these figures.

Can You Be Excluded from Paying the Capital Gains Tax?

You may be overwhelmed if you think you must 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.

A primary residence's capital gains can be permanently excluded from your income.

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 sell it for $550,000 three years later, 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 exceed 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 $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.

How Do You Qualify for an Exemption on Capital Gains Tax?

One of the most important ways to avoid the capital gains tax is to ensure you meet the living requirements in your home.

To claim the whole exclusion, your home has to be your primary residence. A primary residence is the leading home you live in throughout the year.

To get the primary residence exclusion, you need to meet three requirements.

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 for two consecutive years as long as it's 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 partly on how long you hold the asset before selling.

The IRS only allows you to claim this exemption every two years.

So, you cannot claim your most recent sale if you sold another property in the last two years, which also qualified for a long-term capital gain exemption.

Remember to File For Your Exclusion For That Tax Year

Remember that you have a limited time from the day you move out to sell your house 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 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 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 began a new job at least 50 miles from home.

Third, either of the above is true of your spouse, a co-owner of the home, or anyone else for whom the house was their residence.

What Other Ways Can You Be Exempt from Capital Gains Tax?

If any of the following events occurred when 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 manufactured disaster.

You can no longer maintain your home because you experience significant financial difficulty, such as a job loss.

Your home becomes less suitable as a primary 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 cannot 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 years before you sold it.
• You didn't live in the house for at least two years in the five years before you sold it.
• You already claimed the $250,000 or $500,000 exclusion on another home two years before the sale of your primary residence.

Can You Deduct Expenses from the Capital Gain of Your Home Sale?

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.

However, note that all expenses related to your home cannot be deducted from your net gain.

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 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.

Remember that home improvements do not include ordinary repairs and maintenance on your house.

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 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 capital gains tax exclusion requirements and owe nothing.