What you Need to Know about Capital Gains Taxes on Real Estate
Selling your home at a high price can be lucrative, but it may also come with tax implications. The IRS might require you to pay capital gains taxes on the profit you earn from the sale. Here’s a detailed look at how these taxes work and how you might avoid them through certain exclusions.
When you sell your home for more than you purchased it for, the profit is classified as a capital gain and may be taxed. The capital gains tax rate is determined by factors such as your taxable income, filing status, and the duration for which you owned the property before selling it.
Section 121 Exclusion
The IRS Section 121 exclusion, or the home sale tax exclusion, allows homeowners to exclude a portion of their capital gains from taxable income. Single filers and married individuals filing separately can exclude up to $250,000, while married couples filing jointly can exclude up to $500,000. Any profit exceeding these limits may be subject to capital gains tax.
Calculating Capital Gains Tax
The amount of capital gains tax owed is based on the profit from the sale, which is the difference between the sale price and the original purchase price of the home.
- Short-term capital gains: If you owned the home for a year or less, the profit is taxed at your ordinary income tax rate.
- Long-term capital gains: If you owned the home for more than a year, the tax rates are lower, ranging from 0%, 15%, to 20%, depending on your filing status and taxable income.
As an example, if you purchased your home twenty years ago for $270,000 and sold it for $820,000, the profit would be $550,000. If you’re married and filing jointly, $500,000 of that gain might not be taxed due to the exclusion, and $50,000 could be subject to long-term capital gains tax.
Eligibility for the Home Sale Capital Gains Tax Exclusion
To qualify for the Section 121 exclusion, the following conditions must be met:
- Primary Residence: The home must be your principal residence, which includes various types of homes like condos, co-ops, mobile homes, or houseboats. The IRS requires that this is the home where you spend most of your time.
- Ownership and Use: You must have owned and lived in the home for at least two out of the five years before the sale. These two years do not need to be consecutive.
- Frequency of Exclusion: You cannot have claimed the exclusion for another home sale within the two years before this sale.
- Not Acquired Through Like-Kind Exchange: The home must not have been purchased through a like-kind exchange (1031 exchange) within the last five years.
- Expatriate Tax: You cannot be subject to the expatriate tax, which applies to certain individuals who have renounced U.S. citizenship or residency.
Special Considerations
There are exceptions to these rules. For example, individuals moving to nursing homes or changing employment locations may still qualify for the exclusion even if they do not meet the standard ownership and use requirements.
Long-Term Planning for Capital Gains Taxes
Passing your home to a beneficiary can provide tax advantages through a step-up in basis, which adjusts the value of the home to its fair market value at the time of inheritance. This can significantly reduce the capital gains taxes owed if the beneficiary decides to sell the property.
Understanding the intricacies of capital gains taxes on real estate involves knowing the rules and exclusions available. Consulting with your tax professional can help you make informed decisions and potentially save a significant amount of money. Whether you’re selling your home or planning to pass it on to beneficiaries, careful planning is essential to maximize your benefits and minimize your tax liability.
Source: Accounting Today; IRS.gov