DISCLAIMER: As a friendly reminder, this blog post is meant to be used for educational purposes only, not legal or tax advice. If you need help determining the taxes on your home sale, please consult a skilled tax professional.
Taxes make you feel like life is nothing but a miserable existence. But when it comes to your home sale, there’s a silver lining: Thanks to the Taxpayer Relief Act of 1997, you likely don’t have to fork over a single penny of your home sale profits to the federal government. And this wasn’t always the case.
It used to be that you had to pay capital gains when you sold your house unless you resorted to one of two loopholes—the “rollover rule,” which required purchasing another house within two years, or claiming a one-time $125,000 exclusion (only applicable to sellers over the age of 55).
Legislators said “pish-posh” to those regulations over 20 years ago, and homeowners ever since have reaped the benefits. Nevertheless, selling your home remains a complex and expensive endeavor, and taxes are just the tip of the iceberg on your long to-do list.
We pored over all the relevant IRS home sale tax explainers and consulted seasoned pros Brett Young, a top-selling real estate agent in Indianapolis, and Monika Heaton, founder and CEO of tax planning and preparation firm Decision Financial, to answer the most common home sale tax questions one by one (and in plain English!)
1. Do you have to pay capital gains taxes on your home sale?
It depends, but most home sales are 100% tax free. Let’s explain.
The capital gains tax is the tax imposed on the sale of a capital investment, such as real estate. Generally speaking, the government wants a piece of any “capital gains” (aka profit) you make from selling off assets like stocks, bonds or property.
However, Uncle Sam views homeownership as a wealth-builder and stabilizer for the U.S. economy and therefore incentivizes Americans to own real estate with generous tax breaks. Think about it—if you sold your home only to hand over half the proceeds to the government, would you even invest in a house in the first place?
Enter the capital gains tax exclusion: a rule that allows single tax filers to exclude up to $250,000 of capital gains on their home sale and married couples to exclude up to $500,000.
2. Do you qualify for the capital gains tax exclusion?
To qualify for the tax exclusion, you need to meet three criteria:
- You’ve owned the home for at least two years.
- You’ve lived in the home as a primary residence for two out of the last five years.
- You haven’t sold a property and taken the capital gains tax exclusion on it within the past two years before the sale of your home.
3. Can I use the capital gains tax exclusion for my vacation or investment property?
Capital gains exclusions only apply to an individual’s principal residence, defined by the IRS as your “main home.” You can only claim one “main home” for tax purposes; if you alternate regularly between properties, then you’ll need to apply a “facts and circumstance” test to find out which home is your principal residence in the eyes of the government.
The capital gains tax exclusion also does not apply to investment properties used for rental income.
However, there is an alternative tax deference vehicle called a 1031 exchange that allows investors to sell productive-use properties (meaning property you make money from, like apartments, rental homes, land, or office space) and buy another like-kind property (another investment property) while deferring payment of capital gains taxes.
4. How do you calculate the profits on the sale of your home?
To determine how much actual profit you’ve made on your home sale, you need to figure out your adjusted cost basis and then subtract that from the sale price.
Simply put, your cost basis is what you paid for the home when you bought it. If you inherited the home, the cost is the fair market value of the home at the time that the former owner died. If you built your home from scratch, throw in land and building costs as well.
Now, you adjust that original cost basis by adding in capital improvements and subtracting depreciation and casualty losses.
The basic formula is:
Original cost of asset
Improvements to asset
Repair of damages to asset
Depreciation to asset
Deducted casualty loss to asset
Adjusted basis of asset
The IRS gives a helpful example for calculating a hypothetical adjusted basis on page 7 of Publication 551. We’ll summarize it for you:
Say you bought a property for $72,275 in 2011. Then you immediately poured $20,000 into remodeling the the property in the form of capital improvements. Between 2011 and 2015, you were allowed depreciation of $14,526. You had a $5,000 casualty loss in 2014 from a storm not covered by insurance and you spent $5,500 repairing damages and extending the property’s useful life. Here’s how your adjusted basis calculation would work:
Confused about some of the terms we mentioned there? Let’s break them down:
An annual allowance for a property’s general wear and tear and deterioration. Note that you can only claim depreciation on areas of your home used for business purposes, like a home office, or part of the home that you rent such as an in-law suite or bedroom. IRS Publication 527 has all the details you need on taking this deduction.
A capital improvement as defined by the IRS is any home improvement that “adds market value to the home, prolongs its useful life or adapts it to new uses.”
A casualty loss is damage, destruction, or property loss as the result of a sudden, unexpected, or unusual event that’s not covered by insurance. Examples include natural disasters such as earthquakes, floods, hurricanes, and tornadoes.
5. Which home renovation projects count as “capital improvements”?
Essentially, capital improvements are any project that would increase the home’s value, make the house last longer, or allow for new uses.
Repairs generally don’t qualify, even extensive ones, if they are simply fixing something broken or returning the house to the original condition.
For example, repairing a few broken slats on a wood floor would not be a capital improvement. But pulling out carpet and replacing it with new wood floors? That’s a capital improvement.
Some other capital improvement examples are a new roof, new siding, a new foundation, adding a bathroom, finishing the basement, and replacing the furnace. The big differentiator here is that a capital improvement is going above and beyond typical maintenance projects.
There are some capital improvements that home sellers commonly overlook, including any costs you agreed to pay for the buyer at closing, such as title insurance, recording fees, legal fees, utility services, and the cost of title abstracts, those count as capital improvements, according to Toby Mathis, Esq.
Factoring capital improvements into your cost basis will be a lot easier if you’ve kept a record of your costs and expenses, so store those new countertop and contractor receipts in a safe place.
6. Do you qualify for a “reduced” exclusion?
In some situations you won’t qualify for the full capital gains exclusion—but you may qualify for a reduced break.
Say as a single filer, you’re eligible for the $250,000 exclusion on your gain; however, you only lived in your house for a year before you sold it—you could then qualify for 50% of the tax break and exclude up to $125,000 of your home sale profits.
In addition, if you switched jobs and had to sell your house because of it, sold because your doctor recommended you move, or suffered an unforeseen circumstance (including involuntary conversion of the residence, disasters or acts of war, death, unemployment, change in employment that makes the home less affordable, divorce, marriage, and birth of children), then you may qualify for the reduced exclusion.
7. How do you qualify for a “partial” exclusion?
Don’t let the jargon confuse you—partial exclusions and reduced exclusions are the same thing, so you’d qualify exactly the same way, according to Heaton, the tax firm CEO.
8. Do you need to report your home sale profit on your tax return?
Any profit you make on your home sale above the $250,000 or $500,000 limit is reported as capital gains on your taxes. If you meet that exclusion, you don’t need to report the transaction. Regardless, though, the IRS will know you sold your home.
The profits will be reported on Schedule D of IRS Form 1040. Failing to do so could result in an IRS sanction.
“It’s usually reported on a form at closing and submitted to the IRS,” Young said.
“The form states the sales amount and that’s where they qualify you for deductions and determine if you’re going to be hit with capital gains.”
The capital gains tax will apply for any proceeds beyond the exclusion cap. The 2018 rate is 0%, 15%, or 20% dependent on your tax bracket.
9. What paperwork should I hang onto about my home sale for tax purposes?
Young says this is an easy answer—hang onto everything.
“You get a bunch of papers at closing, and you don’t want to ever throw any of that stuff away,” he said.
For those of you who don’t have storage for all the documentation, Heaton says to absolutely hold onto these documents in particular:
- Escrow documents (closing statements) for the original purchase
- All refinances done during the life of owning the property
- All receipts on purchases used to make the capital improvements
And if you are one that qualifies for the partial exclusion, you will want to keep documentation in regards to that, like the offer letter for a new job, doctors’ notes, or other pertinent paperwork.
When in doubt, consult HomeLight’s list of everything you need for taxes when selling a home, created with the help of H&R Block’s lead tax analyst.
10. Do divorce home sales still qualify for the capital gains tax exemption?
The capital gains tax break can be pretty straightforward for a single or married person selling their home. But more complicated when divorce enters the picture.
“Remember that if you decide to sell that home, and for some reason you move out, or you sell it five years later after making it a rental, and now you’re divorced—you’re only getting a $250,000 capital gains exemption,” advises Jordan Bennett, a top 1% real estate agent in Mission Viejo, CA.
Use our guide to preserving the capital gains tax break during a divorce home sale, which covers three different scenarios:
- The couple stays married throughout the end of the year in which the home is sold.
- One spouse buys out the other and stays in the home.
- Both spouses continue to co-own the home, though only one ex-spouse lives there.
11. I’m selling my house and moving for a new job—are there any tax breaks?
If you’re selling your home for a new job and you lived in it for more than two years, you’ll qualify for the full capital gains tax exemption.
But if it’s been less than two years, Heaton says, your new job has to be 50 miles away or more from the home you’re selling in order to qualify for a partial exclusion.
As far as the hefty Home Depot bill you’ve saved for the heaps of bubble wrap, tape, and moving boxes all over your house? Unfortunately, the IRS can’t help you there.
You used to be able to deduct moving expenses if your new home was at least 50 miles closer to your new job than your old home was (the distance test), and you’d been working that job full-time for 39 weeks within the first year after you moved (the time test). As Move Buddha explains in its guide: “The Moving Tax Deduction is Dead,” the 2017 tax reforms all but eliminated this deduction with the exception of military relocations (which we’ll explain a little later).
12. I’m selling my house and not buying a new one. Do I still qualify for the tax exemption?
Even if you aren’t buying a new home, you will qualify for the capital gains tax exemption as long as the property you’re selling was your primary residence. “It’s not something you can only take once,” Young said. “Each time you sell your primary home, you have those exemptions.”
13. How does home sale tax work for military members?
If you’re a member of the Armed Forces and your service required you to live outside of your home or move altogether, perk up! There’s a good chance you qualify for a tax deduction.
If you were not able to live in your home for at least 2 out of the past 5 years because you were on qualified extended duty (meaning you were on active duty, ordered to live in government quarters or serve 50 miles from your home) you can still qualify for the capital gains exclusion, as long as you met the 2-year minimum before you left. This suspension can be found in tax code Publication 523 and is designated for:
- Members of the Armed Forces
- Members of the commissioned corps of National Oceanic and Atmospheric Administration
- Members of the Public Health or Foreign Service
- Employees or volunteers of the Peace Corps serving outside of the U.S.
- Employees of the intelligence community
Keep in mind, you can only disregard up to 10 years of your extended duty, so your 5 year test period can’t begin more than 15 years before you sold your home.
Now, if you sold your house because you’re an active member of the Armed Forces en route to your new permanent station, you can partially deduct your move. According to IRS Publication 3, you can deduct:
- Transportation and storage of household goods and personal items
- Travel from your old home to your new home (including lodging)
Tip: The cost of meals is NOT tax-deductible on Form 3093.
14. Are there any other tax implications that come with selling your home?
Typically, you’ll need to settle up your property taxes at closing. They’ll be prorated for the amount of time you lived in the home for the year, though—and if you have an escrow account and the taxes are rolled into your mortgage payment, you likely won’t have to front too much cash.
Header Image Source: (Kristine Isabedra/ Death to the Stock Photo)