Of course you want to make a tidy profit on your home when you sell it. But beware a bite on your earnings: the capital gains tax. If your home has substantially increased in value, you could be liable for a substantial sum when you pay your annual income tax.
Fortunately, there are ways to avoid or reduce the capital gains tax on a home sale so you can keep as much profit in your pocket as possible. Here’s everything you need to know.
What is the capital gains tax?
Capital gains tax is the amount of tax owed on the profit (aka the capital gain) you make on an investment or asset when you sell it. It is calculated by subtracting the asset’s original cost or purchase price (the “tax basis”), plus any expenses incurred, from the final sale price.
For long-term capital gains — on assets owned for over a year — special rates apply. The long-term capital gains tax rates are 15 percent, 20 percent and 28 percent (for certain special assets types, like collectibles), depending on your income.
Real estate, including residential real estate, counts as a taxable asset. Any gains you make from a home sale must be reported to the IRS: You calculate and pay any money due when filing your tax return for the year you sold the property.
While its rates are typically lower than ordinary income tax rates, the capital gains tax can still add up, especially on profits for big-ticket items like a home (the largest single asset many people will ever own). The capital gains tax directly ties into your property’s value and any increases in its value. If your home substantially appreciated after you bought it, and you realized that appreciation when you sold it, you could have a sizable, taxable gain.
How much is capital gains tax in real estate?
Calculating capital gains tax in real estate can be complex. The tax rate depends on several factors:
- Your income tax bracket
- your marital status
- how long you’ve owned the house
- if the house was your primary residence, a secondary residence or an investment property
Note: The tax is only assessed on the profit itself. If you purchased a house five years ago for $150,000 and sold it today for $225,000, your profit would be $75,000. (This is a simplified example, since there are deductions you could take – qualifying home improvements, sale closing costs — that would effectively reduce your net profit.) You would need to report the home sale and potentially pay a capital gains tax on the $75,000 profit.
For the 2022 tax year, for example, if your taxable income is between $41,676 – $459,750 as a single filer, and $83,351 – $517,200 for married filing jointly, you would pay 15 percent on the $75,000 profit, or $11,250.
However, the IRS gives home sellers multiple ways to avoid or reduce their capital gains taxes, primarily if the property they’re selling is a primary residence. You can exempt a certain amount of the profit — up to $250,000 or $500,000, depending on your filing status — from the tax, if you meet certain conditions. Details on this below.
How much is capital gains tax on rental property?
Rental properties don’t have the same exclusions as a primary residence does when it comes to taxes.
So, on the entire profit, you would have to pay between 15 and 20 percent in long-term capital gains taxes, depending on your income and filing status. In some cases, you might pay as much as 25 percent, if you previously claimed a depreciation deduction for the property.
If you plan to sell a rental property you’ve owned for less than a year, try and stretch ownership out for at least 12 months, or it will be taxed as ordinary income. The IRS doesn’t have a ceiling for short-term capital gains taxes and you may be hit with a tax of up to 37 percent.
How to avoid capital gains tax on a home sale
Capital gains taxes can greatly affect your bottom line. Fortunately, there are ways to reduce the tax bill, or avoid capital gains taxes on a home sale altogether. It depends on the property type and your filing status. The IRS offers a few scenarios to avoid capital gains taxes when selling your house.
Avoiding a capital gains tax on your primary residence
You can sell your primary residence and avoid paying capital gains taxes on the first $250,000 of your profits if your tax-filing status is single, and up to $500,000 if married filing jointly. The exemption is only available once every two years. But it can in effect render the capital gains tax moot.
Let’s say a single filer bought a home for $250,000, lived in it, and sold it for $400,000 three years later. Their profit is $150,000. But that’s exempt from any capital gains tax, because it’s under the $250,000 threshold allowed for gains.
Of course, there are conditions. To qualify the property as your primary residence, the IRS requires that you prove that it was your main home where you lived most of the time. You’ll need to show that:
- You owned the home for at least two years.
- You lived in the property as the primary residence for at least two out of the five years immediately preceding the sale.
However, there is wiggle room in how the rules are interpreted. You don’t have to show you lived in the home the entire time you owned it or even consecutively for two years. You could, for example, purchase the house, live in it for 12 months, rent it out for a few years and then move in to establish primary residence for another 12 months. As long as you lived in the property as your primary residence for a total of 24 months within the five years before the home’s sale, you can qualify for the capital gains tax exemption.
Avoiding capital gains tax on a rental or additional property
If you own an additional property that you plan to sell, you will need to plan ahead to lower your tax liability. There are several ways to mitigate any capital gains tax.
Establishing the rental as primary residence
You might find that an investment property you rent and plan to sell has spiked in value. It may be a good idea to move into the rental for at least two years to convert it into a primary residence to avoid capital gains. However, you won’t be able to exclude the portion you depreciated while renting the property.
You’ll lose primary residency status on your main home, but it can always be gained later by moving back in after the sale of the rental property. As long as you don’t plan to sell the main home for at least two years, you can re-establish primary residency and qualify for the capital gains exclusion later.
You can also take advantage of a 1031 exchange. Known as a like-kind exchange, it only works if you sell the investment property and use the proceeds to buy another, similar property. You’re basically putting off capital gains tax indefinitely; as long as you keep putting the sale of the proceeds into another investment property, you can avoid capital gains taxes.
The 2017 Tax Cuts and Jobs Act created Opportunity Zones — areas around the country that have been identified as economically disadvantaged. If you choose to invest in a designated low-income community, you’ll get a step up in tax basis (your original cost) after the first five years. And any gains after 10 years will be tax-free.
If you still have capital gains after taking advantage of exemptions and exclusions, focus on lowering the amount of the taxable profit or gains. Some qualifying deductions include:
- The cost of repairs to a home or investment property.
- Improvements and upgrades such as adding a bedroom or renovating a kitchen.
- Losses in investment property income due to tenants unable to pay rent.
- Cost of legal, professional and advertising fees to evict a tenant or find a new one.
- Closing costs from the property sale.
Remember to keep organized records and documents including receipts, bills, invoices and credit card statements to support your expense claims in case you’re audited.
This video is a good resource that goes into more depth on capital gains.
Watch more courses in Bankrate’s video series to see what other exemptions to look out for this year.