Capital Gains and Your Home Sale
For home sellers who may be unfamiliar with how appreciation is generally taxed, capital gains can be a complicated process to understand. Because the rules for capital gains periodically change, it is not recommended for sellers to base a current sale off one that was completed two decades ago. The following information details the conditions, exemptions, and terms of capital gains, and how it is most likely to affect the net profit at the end of the sale.
What Are Capital Gains?
Capital gains refer to the taxes that are used for any item that has increased in value over time. It can technically apply to anything from a car to a limited-edition action figure. For example, if a buyer purchased their home for $100,000 and sold it 40 years later for $700,000, their capital gain would be $600,000 minus certain expenses. The IRS doesn't tax this number separately - they essentially add it to a person's regular income for the year and then tax according to the final numbers.
What Is the Progressive Scale?
The progressive scale is based on the person's income:
- Sellers making under $37,950 per year are exempt from capital gains taxes
- Sellers making between $37,951 and $418,400 per year are taxed at 15%
- Sellers making over $418,400 per year are taxed at 20%
Sellers can expect their overall net worth to be taken into account when determining the percentage.
How Capital Gains Exemptions Work
Exemptions for capital gains are made for owners who live in their home for at least two years and sell their home within five years of the date of their original purchase. Each owner of the home is allowed to deduct up to $250,000 worth of capital gains. If three people own the home, the total would be up to $750,000. This is true whether the owners rent it or not, as long as the owners have lived at least two full years in the property.
For example, a married couple can live in the home for two years, rent it out for three years, sell at the top of the market, and then deduct up to a $500,000 from their taxable income. These exemptions have limitations on them, made specifically to limit the tax breaks for professional home flippers or other investors. A seller is only able to take advantage of these exemptions once every two years.
The seller is allowed to deduct all expenses related to the home sale, such as closing costs, agent commission, or staging fees. This includes the fees both from the original sale of the home and the current sale. They can also deduct any renovations they made to the home throughout the years. (These deductions come off the final sale number.)
What does and doesn't qualify as a major renovation can become tricky for sellers, especially if there were a number of projects completed over a number of years. Therefore, homeowners should keep detailed records of what they do to the home throughout the course of ownership.
The best thing sellers can do is talk to a financial expert who specializes in both capital gains tax and real estate law. Homeowners can also consult with an experienced real estate agent to learn more about how they can close the gap and reduce their capital gains.
How to Avoid Paying Capital Gains Tax
Capital gains tax can be offset by capital losses. For example, if a homeowner has two major assets—one that has increased in price and one that has fallen over time—and the homeowner were to sell both at roughly the same time, the profits and losses could cancel each other out.
Additionally, there is a way to delay capital gains tax through a 1031 exchange. With this option, the seller would be purchasing a property that's roughly the same price as the one they just sold. If a seller buys a home for $500,000 and sells it for $1,000,000 and were to purchase another $1,000,000 property, they would defer their taxes until they sold the property at a later date.
Capital gains tax can sometimes be difficult to understand, but the right professional can assist the seller with the right details. A 1031 exchange can be especially complicated, so it is usually worth it for sellers to work with a professional throughout the process.