DISCLAIMER: This article is meant for educational purposes only and is not intended to be construed as financial, tax, or legal advice. HomeLight always encourages you to reach out to an advisor regarding your own tax situation.
If you’re currently in the process of selling your home or just joyfully accepted a competitive buyer offer, you may be reeling with the unexpected realization that capital gains are taxable.
…Or are they? You may qualify to exclude up to $500,000 of that profit outright — courtesy of Uncle Sam.
You can minimize your capital gains tax — taxes levied on profits from selling capital assets — in two key ways: “Keep excellent records of all deductible expenses, and work with a tax professional any year you sell a house,” says Christopher Skinner, attorney at law and Certified Public Accountant (CPA) with over 20 years experience in public accounting and private industry.
We’ve sifted through the most up-to-date IRS tax guidance for home sellers in 2021 (Topic 409 is your friend, along with Publication 523) and compared notes with Skinner to provide you with 6 key tax breaks that can save you money come April.
What are capital gains?
Generally speaking, the government wants a piece of any “capital gains” (aka profit) you make from selling off assets like stocks, bonds or—you guessed it—property. Luckily, many of the pricey parts of homeownership — large renovations, mortgage interest, and property tax — can be deducted to lower what the IRS wants you to pay taxes on when you sell.
How do I cash in on that, you ask? Here are the top ways to minimize your capital gains tax obligation.
1. Exclusion of gain
The exclusion of gain isn’t technically a deduction, but it’ll impact your bottom line to the same effect: less taxable gain.
Most sellers who sell their personal residence (as opposed to an investment property or second home) are qualified to exclude $250,000 if single or married and filing separately and $500,000 if married and filing jointly.
To fully understand the beauty of exclusion of gain, you’ll need to learn a couple new vocabulary words:
- Capital gains: the taxable profits you make from the sale of your home. Capital gain is equal to how much you sell your home for minus your home’s cost basis.
- Cost basis: The original purchase price of the home.
- Adjusted cost basis: Whatever you paid for your home plus any capital improvements you put into your home.
If your capital gains minus your cost basis are less than the exclusion of gain you qualify for, you won’t owe the IRS any taxes on your gain. If your capital gains minus your cost basis exceed your exclusion amount, you’ll pay tax on only the overage. And, if you don’t qualify for an exclusion at all, you’ll be taxed for your entire gain.
How do I know if I qualify for the exclusion?
According to IRS Publication 523, in order to exclude the above gains from your tax obligation, you need to meet the following 3 qualifications:
Ownership: You owned the property for at least two of the last five years.
Use: You lived in the property for at least two of the last five years.
Look-back: You did not exclude the gain from the sale of another house within two years from the sale of this house
Sofia and Garett are selling their primary residence. They purchased the home for $350,000 and spent $50,000 on capital improvements for an adjusted basis of $400,000. They sell the home for $750,000 (in a red hot seller’s market) for a capital gain of $350,000. Sofia and Garett qualify for the $500,000 exclusion of gain, and thus none of their sale profit will be taxed by the IRS.
So, if your profit is less than your exclusion, does the IRS even want to know about the sale at all?
“Definitely still report it,” Skinner cautions. “If you don’t, the IRS may well assume it’s all gain.” To help you report the sale to the IRS, Skinner says you should look out for a 1099 issued by the sale’s title company.
2. Partial exclusion of gain
Let’s say you haven’t had the opportunity to own or live in your house for two of the last five years before the date of sale. The IRS says you may still qualify for a partial exclusion of gain.
To qualify, your main reason for selling your home must be a change in workplace location, a health issue, or an unforeseeable event. To find out how much of your gain is taxable, the IRS directs taxpayers to Worksheet 3.
Luke bought a home on the East Coast with the intention to plant roots near his job. However, Luke’s mother unexpectedly develops a health condition which requires special in-home care. Luke quickly decides to relocate closer to his mother to help take care of her and to advocate for her throughout her treatment. Because Luke’s job requires onsite attendance, his abrupt move leads to loss of income and financially requires him to sell his home. Luke qualifies for the partial exclusion of gain. He works with his tax advisor and uses Worksheet 3 to determine how much of his gain is still taxable.
3. Capital improvements
If your home sale profits exceed the capital gains exemption threshold ($250,000 for single filers, and $500,000 for married filers), it’s time to review any capital improvements you made to the home while you owned it.
“Adding capital improvements to your cost basis mitigates your tax liability by reducing your taxable gains,” Skinner says. It boils down to this equation:
Taxable income = amount realized – adjusted basis
Think of repairs as reactive projects you take on when something breaks. Capital improvements, in contrast, aren’t reactive repair projects but rather forward-thinking and intentional projects done with the intention to add value.
Modernizing your kitchen into this century or opening up your floor plan are capital improvements that differ from repairs because they are investments in the value of the home — and they’ll reflect in the home’s sale price. That’s why they raise the cost basis of your home.
Fixing a leaky faucet or repairing a hole in your roof, however, don’t add value. They simply maintain the baseline condition and value of the home. While they’re necessary for keeping your home in working order and may cost a bit, they can’t be deducted from your home sale.
So what can be deducted? Page 9 of IRS Publication 523 provides specific examples of improvements that actually add to the value of the house and, thus, can be deducted from your tax obligation:
- New bedroom, bathroom, deck, garage, porch, or patio
- New landscaping, driveway, walkway, fence, retaining wall or swimming pool
- New storm windows or doors, roofing, siding, or satellite dish
- New attic, walls, floors, or pipes and ductwork
- New HVAC, furnace, central humidifier, central vacuum, air/water filtration systems, wiring, security system, or lawn sprinkler system
- New plumbing, septic system, water heater, soft water system, or filtration system
- New built-in appliances, kitchen modernization, flooring, wall-to-wall carpeting, or fireplace
“It’s important to remember that the IRS only lists examples of capital improvements,” Skinner notes. “It’s not a definitive list.” The key to determining whether a capital expenditure is a repair or a capital improvement comes down to added value.
Remember that you can’t deduct capital improvement projects from your taxable income like a mortgage interest or property tax write-off. These reductions of capital gain are instead added to your home’s cost basis to decrease the amount you’ll owe in taxes when you sell.
Miles purchases a home for $380,000 and spends $20,000 on a bedroom addition and $10,000 on a kitchen remodel. His adjusted basis is $410,000. He sells the home for $600,000 and subtracts his adjusted basis from his amount realized: $600,000 – $410,000 = $190,000. Because Miles qualifies for the $250,000 exclusion, he owes no gains tax.
4. Selling expenses
Selling expenses quickly add up — averaging $31,000 in fees for expenses like advertising, agent commissions, and other closing costs. Luckily, you can subtract all of these selling expenses from your gain to lower your tax liability.
Yet another reason why it’s worth it to hire a top real estate agent — who’ll guide you through the daunting home selling process to sell your house faster for more money: You cane to deduct their fees fully from your capital gains tax obligation.
Skinner says it’s vital to keep track of all the money you spend attracting high bids on your home. “Remember that staging is also a selling expense,” he remarks, alongside these other selling expenses detailed in IRS Publication 523:
- Real estate agent commissions: It’s customary for the seller to pay commission fees for the sale, which are split between the listing agent and buyer’s agent. HomeLight’s Commission Calculator allows you to access commission data specific to your city — the national average is 5.8% of the sale price. This commission covers your agent’s pricing assistance, marketing prowess, and expert negotiation skills, among other services.
- Transfer taxes/recording fees: Transfer taxes are one-time fees levied on home sales as a percentage of the property’s value, typically paid by the owner. Transfer taxes cover the cost of transferring the home’s deed to its new owner and vary by state, county, and city. Some states charge no transfer taxes at all. If you do have to pay them, though, they can be treated as selling expenses.
- Settlement or escrow fees: Settlement fees, sometimes called escrow fees, are paid directly to the third-party company that handles the money and title transfers for your home sale. Settlement fees are generally divided between the buyer and seller depending on what the purpose of the specific settlement fee is and what is customary in the market where the property is located, but who pays these fees can be a matter for negotiation in many instances. Expect them to cost about 1% of the home’s sale price.
- Recording fees: Recording fees are a one-time expense charged by the government to record the sale of your home to its new owner. Whether the buyer or the seller pays the fee is up to negotiation. Recording fees vary widely by county, from as low as $15 to upwards of $60 per page.
- Advertising fees: How much did you spend marketing your home to buyers? 90% of homes staged prior to listing left the market faster than unstaged homes, according to the Real Estate Staging Association, but staging adds up to $1,500 on average. Tack on home photography and you’ll have a sizable pot of deductible costs. Just be careful not to double-dip; if your agent included the costs of these marketing services in their commission, you can’t count them as selling expenses twice.
- Attorney fees: If you hire a lawyer to help sell your home (some states require it), expect to pay $200 – $600 an hour.
- Mortgage points or loan charges paid on behalf of buyer: Seller-paid points are concessions paid by the seller on behalf of the buyer to lower the interest rate on the home’s mortgage. They’re paid in a lump sum by the seller to sweeten the sale for a buyer. How much you spend on points will vary depending on the number of points you buy and the home’s price.
- Appraisal fees: Appraisal fees are paid towards the obtaining of a neutral assessment of your home’s value and are typically paid by the buyer and required by their lender, although you can choose to cover some portion to make a deal more attractive. Appraisal fees are $300 – $400 on average.
It’s likely that you won’t incur every single one of these costs when you sell your home.
Keep track of your receipts and invoices for all services pertinent to selling your home so you know where you stand before tax season. Many closing costs will be detailed in the settlement sheet prepared by your closing agent (or, in some states, an attorney).
Avery and Taylor’s home’s adjusted basis is $350,000. They sell their home for $850,000. Their selling fees, including agent commissions, escrow fees, attorney fees and advertising expenses are $65,000. To calculate their amount realized, they subtract their selling expenses from their home’s sale price: $850,000 – $65,000 = $785,000. Their taxable gain is equal to their amount realized minus their adjusted basis: $785,000 – $350,000 = $435,000. Because they qualify for the 500,000 exclusion, Avery and Taylor aren’t required to pay any capital gains tax.
5. Mortgage interest deduction
Though it’s not technically a seller-specific tax break, we’d be remiss if we didn’t mention the mortgage interest tax deduction. Homeowners have long enjoyed the mortgage interest tax deduction as one of the major benefits of owning a home. No matter how long your house has been on the market, if you have a mortgage on the house you’re selling — and it’s your main house — there’s a good chance you can deduct your mortgage interest from your income taxes.
The IRS allows you to deduct interest on up to $750,000 of a loan for homes bought after December 15, 2017 — down from $1 million for loans obtained before the Tax Cuts and Jobs Act (TCJA) took effect. Because most homes nationally cost well below $750,000 according to the 2021 Census data on home sales, most homeowners are able to deduct mortgage interest in its entirety using Form 1040, Schedule A on Itemized Deductions.
In addition to mortgage interest, you should also check into whether you can deduct mortgage “points,” which describe charges you may have paid to get a mortgage like prepaid interest or loan origination fees.
However, keep in mind there are 9 requirements you must fall under to “deduct the points in full in the year you pay them,” which you can find on this page.
“Typically, if you own a home with a mortgage you will itemize,” Skinner says. “But keep in mind, the standard deduction has increased so there are circumstances where the standard deduction is more favorable. For instance — if you are retired and the house is paid for.”
If your itemized deductions don’t add up to be greater than the standard deduction, it’s in your interest to take the standard deduction: $12,550 for single filers and $25,100 for those who are married and file jointly in the 2021 tax year. If your combined deductible expenses, including things like property taxes (see below), mortgage interest, and charitable contributions don’t exceed this amount, it doesn’t make sense to itemize.
Not sure where you stand? Work with a tax professional who can both guide you through the itemizations form and confirm if you can write off mortgage interest and mortgage points, given the requirements.
Naomi is single and paid $2,500 in property taxes and $10,000 in interest on a mortgage loan in 2021. She’s wondering whether it makes sense to itemize and trim her taxable income by $12,500 or take the standard deduction. She has no other deductible expenses. Naomi sees that, because the standard deduction for a single filer is $12,550, it’s advantageous to take the standard deduction.
6. State and local property taxes
The average property tax paid nationally on a yearly basis is $2,471, according to WalletHub and Census Bureau data. Luckily, all of that tax is likely to be deductible for the average American. While this tax break isn’t necessarily specific to sellers, you can still take advantage of it for any taxes you paid for the portion of the year you still owned the home.
The 2017 GOP tax bill caps the amount a homeowner can deduct for property taxes, state and local income, or sales tax at $10,000, and you can only deduct property taxes if they were assessed by your local government and paid the previous year.
What does this mean for home sellers? If you’re up to date on your property taxes at the time of home sale, you can use what you paid last year in taxes to figure out your deduction for this year up until the property’s sale date — up to $10,000.
Just like mortgage interest, property taxes are an itemized deduction. Get acquainted with Schedule A (Form 1040) to familiarize yourself with how itemizing real estate taxes works. As always with itemization, it’s sometimes advantageous to take the standard deduction. It’s always worth consulting a tax professional to accurately assess your situation and crunch the numbers.
Malcolm and Gwen paid $1,000 in real estate tax for the year prior to the year in which they sold their house. In the year in which they sold their home, they legally owned the property for 230 days. To calculate their deduction for this year, the number of days they owned the property in the year of sale (230) by the number of days in a year (365, or 366 in a leap year) to come up with this decimal fraction of a year: 0.630. They multiply the decimal by the amount they paid in the year prior to sale: 0.630 x $1,000 = $630. This is Malcolm and Gwen’s property tax deduction.
Types of selling expenses that you can’t write off
There are more than a few deduction myths on the internet. Don’t fall into the trap of assuming you can write off these expenses, and remember that tax law is a constantly evolving beast. The latest IRS documentation or a tax professional should always be consulted for the most accurate information.
Thought you could deduct the cost of a U-haul, packing tape, boxes, or moving crew? Sorry, that’s simply not a thing — unless you’re a member of the military.
According to the IRS Publication 3, you may be able to exclude moving expenses from your income only if you meet the following conditions:
- You’re a member of the Armed Forces on active duty.
- You’re relocating permanently for a change of station, due to a military order.
If you meet these criteria, you can claim the cost of your moving expenses using Form 3903. Note, however, that you can only deduct what the IRS considers “reasonable for the circumstance of your move,” which does cover transportation and storage of your possessions and travel from your old home to your new home, including lodging. It does not, sadly, include the cost of meals.
General home repairs
While you are allowed to increase your cost basis by tacking on additional costs spent on capital improvements for the home, you aren’t allowed to deduct run-of-the-mill repairs necessary to maintain your property’s condition or get it ready for sale under current tax code Publication 523.
Confused about the difference between a repair and a capital improvement?
“For some homeowners, it can feel like a murky area,” Skinner says. The key difference is added value.
Repairs are things you do in response to something broken to keep things at a baseline state of function — mowing the lawn, unclogging pipes, repainting dingy walls.
Capital improvements, on the other hand, are forward-thinking projects you do with the intention of adding value.
For example, you can’t deduct the cost of cleaning the carpets in your home or hiring a lawn service to keep up with the grass. You can, however, deduct the cost of finishing a basement, which has a 70% ROI, or replacing unsightly old floors with polished hardwood, which will boost your home’s value by $6,555 on average.
Larissa decides to tackle some serious home TLC over the weekend. On the agenda: building a paver patio to create a clearly identifiable entertainment zone outside her home’s main entrance, fixing her tub’s unsightly grout, and hanging up a fresh set of curtains in her bedroom to improve the aesthetics of the space. Which of these are deductible?
The answer: only the paver patio, which adds $3,563 in value. While routine tub repairs and new window treatments do make a space more habitable and pleasant, neither are considered capital improvements.
What can I deduct on the sale of my second home?
“Other than the loss of the exclusion, the other rules apply,” Skinner says. That means that while you must pay capital gains tax on any profit from selling a second home, you can still qualify for the following deductions:
- All selling expenses should still be figured into your amount realized to minimize your taxable gains.
- In most cases, sellers can still deduct full mortgage interest for a home loan up to $750,000 on homes purchased after December 15, 2017 on their second home.
- “State and local property taxes are generally deductible,” according to the IRS, and you can still deduct up to $10,000 in state and local taxes total between all properties you own per tax return. If you’re already meeting or exceeding that limit with your first home, you won’t be able to deduct additional property tax from your second home.
As is the case with most tax situations, Skinner says it’s wise to consult a tax adviser to confidently maximize your deductions, which vary state-to-state and year-to-year.
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