When you sell your home, you stand to receive an influx of cash. Though there are several costs associated with a home sale, you can likely still bank on the fact that you’ll be depositing a lump sum in the near future. But before you start planning how you’ll use the money or start looking for a new home, you’ll want to understand whether you fall under the criteria of the capital gains tax. If so, the profit from your home sale could end up being smaller than you expected.
What is a capital gains tax?
A capital gains tax is a fee on the profits gained from the sale of an asset. This tax appears in transactions involving various assets—bonds, stocks, boats, cars, and real estate. In real estate, it’s common for homes to appreciate, often leading to a situation where the seller sells the property for more than they originally purchased it. The capital gains tax on the sale of a home is assessed on the difference between those two prices.
Avoiding Capital Gains Tax on a Home Sale
- The 2-in-5 rule: If you have owned the home and it has been your primary residence for two of the five years leading up to the sale, you can exclude up to $250,000 of gains if you’re single, or $500,000 if you’re married and file a joint return. If the profit exceeds these amounts, then the excess is reported as a capital gain. The two years of living in the home don’t have to be consecutive, nor do they need to be the final two years leading up to the sale.
- Two-year window: You can claim the $250k or $500k exclusion as long as you haven’t already claimed it on the sale of another home in the past two years.
- Cost of repairs/improvements: In the context of the capital gains tax, the “cost basis” of your home includes the purchase price, certain legal fees, improvement costs, and more. Including the expenses incurred making repairs and improvements to the home will increase the home’s cost basis, thereby reducing the capital gains.
Paying Capital Gains Tax on a Home Sale
Sometimes, avoiding the capital gains tax may not be possible. If these criteria fit your situation, the gains from the sale of your home may be fully taxable:
- The home you sold is not your primary residence
- You owned the home or lived in it for less than two years in the five years leading up to the sale
- You purchased the property through an investment exchange (known as a 1031 exchange)
- You are subject to expatriate taxes
- You sold another home within the previous two years and used the capital gains exclusion on that sale
Capital Gains Tax Rates
Capital gains tax rates break down into two basic categories: short- and long-term. Short-term capital gains tax rates apply if you owned the home for less than a year. The rate is usually the same as your ordinary income. For example; if you purchase a home, home values in your area go through the roof within the first few months, and you decide to sell right away to take advantage of the competitive market, you’ll be required to pay capital gains tax on the sale. Long-term capital gains tax rates apply if you own the home for longer than a year, and are taxed at 0%, 15%, and 20% thresholds.
For more information on the financial characteristics of a home sale, read A Guide to Understanding Escrow.