“Our new Constitution is now established, and has an appearance that promises permanency; but in this world, nothing can be said to be certain, except death and taxes.” – Benjamin Franklin
What Is Capital Gains Tax?
If you’re planning to sell your home now or at some point down the road, you may be wondering if you’ll end up paying what’s known as capital gains tax. After all, just about everything is taxed these days! So, what is it and how do you potentially avoid it?
Basically, capital gains is a tax you’re required to pay when you sell an asset that has increased in value since you purchased it.
So, let’s say you bought your home for $250,000 in 1999 and recently sold it for $450,000. The $200,000 increase in value is considered a capital gain and subject to taxation.
However, you can exclude all or part of that gain on your federal taxes if you meet basic criteria and profit thresholds. You may not even need to report it on your taxes!
How Do I Avoid Capital Gains Tax When Selling My Home?
First, let’s get this out of the way. If you file as single with the IRS, up to $250,000 of your capital gain is exempt from taxes. For married couples filing jointly, that number goes up to $500,000.
All of that money goes into your bank account, and not the government’s pocket if you meet three basic qualifications:
This one is pretty simple. You must have owned the home for at least 2 years out of the last 5 (up to the date of closing on the home). If you’re married and file jointly, only one spouse has to meet the ownership requirement.
You must also have lived in the residence for at least 2 of the previous 5 years. This is cumulative, not consecutive. All that’s required is 24 total months. However, unlike the ownership requirement, each spouse must meet the residence requirement individually. Here's an example: you lived in your home the first year, rented it out for 3 years, and stayed in it for the fifth year, you could still be exempt from paying capital gains tax.
You haven’t claimed this exemption in the last two years. The IRS calls this the “look back” requirement. If you didn't sell another home during the 2-year period before the date of sale (or, if you did sell another home during this period, but didn't take an exclusion of the gain earned from it), you meet the look-back requirement.
Of course, there are eligibility exceptions. Here’s a list of circumstances that may qualify you for a full or partial exclusion of gain. You can read more about each on the IRS website:
- Separation or divorce that occurred during the ownership of the home.
- Death of a spouse during the ownership of the home.
- Your previous home was destroyed or condemned.
- You were a service member during the ownership of the home.
- You acquired or are relinquishing the home in a like-kind exchange.
- You took or were transferred to a new job in a work location at least 50 miles farther from the home than your old work location.
- You moved for health-related reasons such as to obtain or provide care for yourself, your spouse (co-owner), or a family member.
- Other unforeseeable events.
Just remember that if you do not meet the three basic requirements, you’ll need to demonstrate any other potential qualifying circumstances to the IRS. Remember to always talk to a licensed financial professional to better understand your tax obligations. Your PorchLight agent would be happy to recommend a local expert to help you unravel capital gains taxes.
How Much Capital Gains Will I Have to Pay?
If you think that you’ll owe capital gains tax, how much you might pay depends on your income and filing status. Here’s a quick chart to help you out.
A couple of examples:
Chris bought a condo 5 years ago for $150,000 and sold it in 2021 for $450,000, netting him a gain of $300,000. Since he files his taxes as single, the first $250,000 is excluded. Chris also makes $65,000 annually, so his capital gains tax rate would be 15% and he would pay $7,500 on the $50,000 of gains.
Amelia and Jeremy are married and purchased their home in 2013 for $500,000. Thanks to a low-inventory market, they sold their home at the end of 2020 for $1.3 million, giving them a capital gain of $800,000. As a married couple filing jointly, the first $500,000 is excluded, but their combined income is $625,000 annually, placing them in the 20% tax rate column. So, their capital gains tax on $300,000 is $60,000.
How Do I Avoid Paying Capital Gains Tax When Selling My Home?
If you’re thinking about selling your home, your first step is to contact your PorchLight agent and have them provide a Comparative Market Analysis (CMA) which will show you the current value of your home. You can then get a ballpark figure of your capital gain if you decide to sell.
If it looks like you’re going to be required to pay capital gains tax, there are ways to potentially reduce how much you might need to pay.
First, you can deduct significant improvements from the profit of your home sale (receipts will be required). This does not mean upkeep, like cleaning the carpets or hiring a weekly gardener. It’s more substantial items such as:
- Adding a bedroom, bath, garage, deck, porch or patio
- Installing landscaping, a driveway, fence, retaining wall or sprinkler system
- Putting in a new heating system, central air-conditioning, ductwork or wiring
- Improving the exterior with a new roof, windows or siding
- Adding insulation to the attic, walls or floors
- Installing a septic system, water heater or water filtration system
- Modernizing the kitchen
- Updating the flooring
- Adding a fireplace
In addition, you can also potentially deduct various expenses related to selling your home such as appraisal, closing, escrow, document prep, title search and advertising fees. At closing, you will likely receive a statement listing all of these costs, but it’s always a good idea to keep the receipts for any expenses you pay.
How Do I Learn More About Capital Gains Tax?
While we’ve covered all the general bases in this post, there’s still a lot to learn about capital gains taxes. What if you inherit a home? What if you’re an investor who owned the home for less than two years? These are both great questions, each with its own implications.
You can click here to read the full IRS publication on capital gains or consider finding a financial or tax professional to ensure you avoid either paying or overpaying on taxes.
If you’d like to start the selling process, ask a PorchLight agent about preparing a no-obligation Comparative Market Analysis on your home. Unlike some of the real estate search sites, we don’t use a generic algorithm to determine home values—numbers that are often overinflated.
Your agent will look at the local market as a whole and comps in your area, as well as take into consideration the age, size and state of your home along with any improvements that you might have made. You’ll then receive an accurate and up-to-date report of your home’s value.