Disclaimer: Information in this blog post is meant to be used as a helpful guide, not legal advice. If you need help with a tax question, please consult a skilled tax professional.
Rejoice in this: Rarely do homeowners have to pay taxes on the money they make from selling their house. The IRS allows you to exclude up to $250,000 (or $500,000 if you’re married) of “capital gain” on your main home, which for most sellers covers the gamut.
But it’s possible you will owe taxes on your home sale. Perhaps you moved before meeting the two-year use test or earned more than the exclusion cap due to skyrocketing prices in a hot market. Whatever the case, the next question in your mind is—what tax rate do I fall under?
The answer depends on a few factors, like how long you owned the property, your income level, and your filing status. We’ve scoured over the most recent IRS instructions on capital gains and had accounting expert A.J. Gross, CPA, EA, Founder, and President of ALG Tax Solutions break it all down for us into this handy guide on capital gains tax brackets for home sellers.
Read on to find out your rate (as of 2018 tax rules), and how to calculate your taxes!
Let’s start with the basics: What is a capital gain?
A capital gain, or capital loss, is the profit or loss from the sale of a “capital asset.”
Any asset that is not used in a taxpayer’s trade or business constitutes as a capital asset. This means most of what you own (personal or investment property) can be considered a capital asset—like your house, stocks or bonds, cars, or boats—with a few exceptions. Sell one of these items, and you’ll find yourself with a capital gain on your hands (taxed at capital gains tax rates).
Capital gains differ from ordinary income or ordinary gains, which is money earned from working—like salaries, bonuses, tips, interest income, and gains from your business activities. Ordinary income is taxed at ordinary marginal income tax rates.
For the purposes of this article, we are going to focus on your house as the capital asset in question, and look at the implications of capital gains for home sellers. If you are interested in the treatment of capital gains for other types of capital assets, the IRS has publications you can refer to on assets such as investments or collectibles.
How do you calculate a capital gain on your home sale?
There are two parts to the capital gain calculation—let’s go through each one as it applies to the sale of your house.
- Calculate the adjusted basis of your house (aka, the purchase cost of your house after adjusting for various tax-related items). Here’s a basic formula you can use:
- Next, calculate the capital gain, or profit, on the sale of your home. Use this simple subtraction formula to do that:
If you sold your house for more than its adjusted basis, you have a capital gain. If you sold it for less than its adjusted basis, you have a capital loss.
We’ll talk about how to treat capital gains first and finish off with how to use your capital losses to your advantage.
Breaking down the 2 types of capital gains: short term and long term
There are two types of capital gains: short-term capital gains and long-term capital gains.
Short-term capital gains are profits from the sale of a house that was held for less than one year. Short-term capital gains are taxed at your marginal income tax rates (same as ordinary income).
Long -erm capital gains are gains from the sale of a house held for more than one year. (Be careful‚ this means at least one year and one day). This distinction is important because long-term capital gains are taxed at “favorable” capital gains rates.
What is the capital gains tax?
The capital gains tax is a tax on any capital gains you make during a tax year.
If you sold your house last year (from January 1, 2018 – December 31, 2018), you may have to pay taxes on any profits you made from that sale as part of your 2018 tax filing. But, the amount of tax you owe will depend on:
- Whether the gain is short term or long term
- Whether you qualify for the homeowner’s exclusion (3-pronged test)
Short-term vs. long-term capital gains rates
Short-term capital gains are taxed at a different rate than long-term capital gains. We touched on them before, but let’s walk through the differences in detail:
Short-term capital gains rates:
If you lived in your house for less than one year before selling it, any gain you made from the sale of your house is taxed at your federal income tax rate. Most people are familiar with the ordinary income tax brackets that they fall under. These are the tax rates you use to pay your federal and state income taxes when you file your tax returns every year.
Long-term capital gains rates:
Long-term capital gain tax rates are slightly different. There are only 3 rates: 0%, 15%, or 20%. They are lower than your ordinary income tax rates and apply to any profits you received from the sale of a long-term capital asset. Most taxpayers will fall under this category, because they will usually own their home for longer than 1 year.
Total taxable income impacts what you owe in capital gains
To find which tax rate you fall under, you first need to determine your total taxable income.
Taxable income is your AGI (Adjusted Gross Income) minus the standard/itemized deduction minus the personal/dependency exemptions.
First, pool all your income and gains to calculate your total Taxable Income to figure out which tax bracket you fall under. Here, you’ll want to add the capital gain on your house to the rest of your income (salary, bonus, etc.).
Next, when you’re calculating the amount of tax you owe, split your short-term and long-term gains apart, and calculate the taxes you owe on them separately. Use the overall tax bracket rate to calculate your tax on any ordinary income and short-term capital gains you have, and use the long-term capital gains rate to calculate your tax on any long-term capital gains you have.
Let’s say you received capital gains of $10,000 in 2018. First, calculate your Taxable Income, making sure to include any capital gains. Let’s say this results in a Taxable Income of $40,000 ($10,000 capital gain + $30,000 ordinary income). You will fall under the tax bracket of 22%, which means your $30,000 of ordinary income is taxed at 22%.
With the same Taxable Income, you also fall under the long-term capital gains rate of 15%, so your $10,000 capital gains are taxed at 15%. In total, you will owe taxes of $8,100 ($6,600 ordinary income tax + $1,500 long-term capital gains tax).
This method prevents double taxation, but ensures you include all your income while calculating the taxes you owe. Don’t worry if this is a little confusing. TaxAct, TurboTax, and Credit Karma, to name a few, have great online tools with tax calculators already built in!
2018 capital gains tax bracket breakdown
Below you can see the differences between the 2018 ordinary income tax rates (aka, short-term rates) and the long-term capital gain tax rates below for the four filing types: Single, Married Filing Jointly, Head of Household, and Married Filing Separately:
Take a look above to see how the short-term rates are higher than the long-term rates—the highest income level is paying a whopping difference of 17%! This is the benefit of having a long-term capital gain vs. a short-term one. The tax rates are lower!
Thankfully, short-term rates can be easily avoided. Just hold your house for greater than one year. If you do, you will not only pay the preferential long-term capital gains rates (as shown in the charts above), but depending on how long you hold your house for, you may also qualify for the homeowner’s exclusion.
3-pronged test for the homeowner’s capital gains exclusion
The Homeowner’s Exclusion is a tax break to lower your capital gains tax. If you meet the exclusion requirements, you won’t need to pay taxes on up to $250,000 of your net profit, or up to $500,000 if filing jointly.
According to Section 121 of the Tax Code, to qualify for the capital gains exclusion, you have to pass these 3 “tests:”
- The Use Test: You must have lived in the home (the home must be your principal residence) for an aggregate of at least two of the five years leading up to the date of the sale (consecutive or non-consecutive years).
- The Ownership Test: You must have owned the home for at least two years.
- The “Other Home” Test: You did not exclude your profit from the sale of another home during the two-year period ending on the date of sale of this home. In other words, you can only exclude one home sale every two years, and can only claim the exclusion once every two years.
There are a few circumstances like divorces, partial exemptions, and other special circumstances (like a constructed/inherited home or a secondary home conversion) that could be trickier to deal with.
If you find yourself in this situation, the IRS’s Publication 523 ”Selling Your Home” has some valuable information you can refer to. Gross also recommends speaking with a CPA or tax attorney to iron out the finer details. He specifically finds principal vs. secondary residence questions to be most challenging for home sellers.
If you meet all 3 tests above, you can apply up to $250,000 (single) or $500,000 (married) as a tax exclusion on the profits. You would only have to pay taxes on the remaining amount of profit (if there is any leftover).
Say the sale of your house resulted in a gain of $300,000. A single taxpayer who qualified for the homeowners exclusion would be able to exclude $250,000 of that gain, and would only have to pay taxes on the leftover profit of $50,000 ($300,000 – $250,000). If the same taxpayer was married, the couple would be able to exclude up to $500,000 of the gain, and would end up paying NO taxes on the sale ($300,000 – $500,000).
If you have no leftover profits, congrats! No taxes owed. According to A.J., “the $250,000 and $500,000 exemptions are quite significant, so most homeowners rarely pay a capital gains tax on their main home.”
If you do have leftover profits, never fear, here is where your preferential long-term tax rates can come in handy.
We already provided the long-term rates in the tables above, but here’s a quick recap:
Simply multiply any leftover profit you have by your corresponding long-term capital gain tax rate (0%, 15%, or 20%) from the tables above to calculate your total tax on the capital gain.
How do capital losses factor into the equation?
So, what happens if the sale of your house results in a capital loss? You have three options here.
- Use your capital losses to offset any capital gains.
Capital losses can offset any capital gains you received during the year. So, say you have a $50,000 capital loss on the sale of your home, but you also have $30,000 in capital gains from the sale of stocks. In that case, you can reduce your gains using your losses (as long as they are both “capital” in nature). This leaves you with a remaining capital loss of $20,000.
- Offset capital losses against ordinary income.
While capital losses are generally not deductible against ordinary income, there is an exception where an individual taxpayer can deduct up to $3,000 of their capital loss against ordinary income every year. From the example above, if you deduct $3,000 from your $20,000 capital loss amount, you have a $17,000 capital loss remaining.
- Carry forward any unused capital losses indefinitely.
If you don’t have any capital gains for the current tax year, and you’ve already offset $3,000 against your ordinary income, you can carry forward any excess capital losses to future years until the entire capital loss amount is exhausted. Using our running example, the $17,000 capital loss can be carried forward every year until it is gone (either by offsetting it against capital gains, or by offsetting $3,000 every year against ordinary income).
If you have both gains and losses, you’ll have to “net” your long-term and short-term capital gains and losses and pay the capital gains tax on the net gain or loss. See Schedule D instructions for more information.
In most cases, you’ll use your home purchase and sale information to complete Form 8949 so you can report your capital gains and losses on Schedule D. Remember that the Form 1099-S (issued for home sales by your attorney, lending company, or title company) will keep you honest with the IRS by reporting your capital gains directly to the government. Check out the reporting exceptions to this form.
Ultimately, the tax implications of selling a house are straightforward, but some tricky situations can present challenges. We recommend checking out our common tips on how to avoid or minimize paying a capital gains tax, our FAQ guide with answers to sellers’ most pressing home sale questions explained in simple terms, and (straight from the horse’s mouth) the IRS’s tips for home sales and their tax implications!
Above all, reach out to a professional tax advisor for more in-depth questions. Your tax professional will be well equipped to answer all your questions and concerns and will be able to give you tax solutions tailored to your individual situation.