It may surprise you to know that many homeowners who sell their properties don’t end up having to pay taxes on the sale — even if they walk away from the closing table with a large sum of money.
While taxes can be complicated, there’s a general (and pretty easy-to-follow) rule for how you can determine if there will be tax implications of selling a house, or if you will be able to keep the total amount earned.
Read along for more insights you can use as you navigate the taxes associated with selling a home.
If I sell my house, do I pay capital gains tax?
After selling a home, the profit from the transaction is known as the capital gain. Home sellers can be granted capital gain exclusion — which means the IRS will allow them to avoid paying taxes on the gain — if they meet the following three criteria:
- Must have owned the property for at least two of the last five years
- Must have lived in the home for two of the last five years
- Must not have excluded capital gain from another home sale in the last two years
When all of these stipulations are met, home sellers can exclude capital gains up to:
- $250,000 for solo owners, or for married couples who file separate tax returns
- $500,000 for married couples who file taxes jointly
You’ll find that in our neck of the woods, most property sales don’t net more than these maximums, which means that many home sellers in Minnesota and western Wisconsin don’t end up paying taxes on gains earned from selling a home.
How to calculate your capital gain
Let’s walk you through the step-by-step process to calculate your capital gain. Keep in mind that this is a generalized estimate, and it’s important for you to work with a tax or accounting expert to ensure you accurately calculate your capital gain.
Start with the original purchase price of the home. We’ll use the number $150,000 as an example.
Next, add the cost of any “capital improvements,” which are defined by the IRS as large-scale projects that add value to your home, prolong its life or adapt it to new uses.
Examples of capital improvements that may qualify:
- New roof,
- Kitchen remodel
- All-new, energy-efficient windows
Examples of improvements that may not qualify:
- Replacing a few shingles
- Fixing broken kitchen cabinets
- Replacing cracked window panes
- Painting walls
- Replacing old carpet
While these are all much-needed repairs, the second set of updates return the house to its original value rather than adding value to it.
For our hypothetical home, $20,000 in renovations will be added to the initial sale price; bringing us to $170,000.
Now, subtract any tax credits you got for the improvements. For example, if those energy-efficient windows earned you a $3,500 tax credit a few years back, you’ll need to remove $3,500 from the above sum. This leaves us at $166,500.
Add the cost of any special tax assessments — not routine assessments — or any amount you paid to restore the property after a natural disaster. This home contributed $0 to special tax assessments; we still stand at $166,500. This number, $166,500, is your cost basis.
Next, you’ll calculate the amount you earned at the closing table ($210,000), less your closing costs (-$900) and the commission you pay your REALTOR® (-$14,700). That total is $194,400.
Your capital gain is the amount you’ve earned on the home at sale, minus your cost basis. In this case: $194,400 - $166,500 = $27,900.
If you’re the above owner, your capital gain is $27,900, well within the exemption range whether you’re filing solo or jointly. And remember, if you meet the criteria set forth above, that amount isn’t taxable — it’s just an asset that you’ve earned! You can use these funds to finance your retirement, put toward a new down payment or travel the world. See? The IRS isn’t always the enemy.
Keep in mind that when you are seeking to exclude your capital gains from tax obligations, you will need to have documentation of every number you submit to the IRS — from proof of the original purchase price and final sale price, to the capital improvements and sale expenses you are claiming.
Be sure to keep receipts for any large repairs you take on yourself, and official documentation of the payments made to contractors, plumbers, roofers, HVAC companies, etc., who have helped you with capital improvements or restoration efforts made after natural disasters.
What if my capital gain is above the maximum allowed?
If your capital gain is above $250,000 (or $500,000 for a couple filing jointly), then you will have to pay capital gains taxes on the sale of your home for the amount above the exclusion. The amount you owe will be determined based on your capital gain, as well as what tax bracket you fall into.
Calculating capital gains taxes can be a complicated process. Consult a tax advisor to help you ensure you pay the correct amount.
Are there any deductions I can take advantage of if I sell my home at a loss?
Unfortunately, losses incurred from the ownership of a private residence aren’t tax-deductible. So while you won’t have to pay taxes on the sale of your home, you also won’t earn anything back in the form of a tax deduction or credit.
What if I’m not selling my primary residence? Is there any way to avoid paying capital gains taxes when selling an investment or vacation property?
The only way to avoid paying taxes when selling a house is to clearly meet the three criteria for a capital gains exclusion. Some homeowners who own rental properties or vacation homes do avoid paying capital gains taxes when selling their property by:
- Moving into their home permanently for the two years before they sell it and
- Making sure to spread their home sales out by two years
As you can see, there really aren’t loopholes when it comes to excluding capital gains. Remember, tax fraud is a serious crime — so you should never claim that you lived permanently in a home if you didn’t.
Key points and next steps
Do these hypothetical numbers have you calculating your own home sale? Don’t go it alone! Reach out today for your custom home value estimate.
Additional resources to consider: