Understanding Capital Gains Tax When Selling Your Home

Your house is your home. You may have spent much of your life decorating it and making improvements to it. When it's time to sell, you may be surprised to learn that your home is considered a capital asset. If you've implemented high-ROI upgrades on your home or live in an area that's experienced growth in market value, you may receive capital gains that are significantly greater than your initial investment.

Depending upon your situation, you may owe taxes to the IRS on the gains from your home sale. Keep reading to learn four things about capital gains before selling your home.

For informational purposes only. Always consult with an attorney, tax, or financial advisor before proceeding with any real estate transaction.

Primary Home Exemption

Thanks to the primary home exemption, the IRS allows you, in most situations, to exempt up to $250,000 if your filing status is single and up to $500,000 if married. For example, if you bought the home six years ago for $400,000 and sold it for $700,000, you'd make $300,000. If you're single, only $50,000 of that $300,000 would be taxable. If you're married, none of it would be.

When the Sale Is Fully Taxable

However, in certain situations, you are not able to claim the primary home exemption. In these situations, you'll be liable for capital gains taxes on the whole net gain. Those situations are:

• The house wasn't your primary residence
• You didn't live in it for at least two full years out of the past five (military and Foreign Service employees receive a break here)
• You didn't own it for at least two years out of the past five
• You've claimed an exclusion for another home within the past two years
• You acquired the home in an investment property exchange

Capital Gains Taxes

Home gains qualify as long-term capital gains because you've owned the home for more than one year. Depending upon your filing status and income, the tax rate on long-term capital gains tax rates ranges from 0 to 20 percent. The thresholds change annually, and most households will pay no more than 15 percent.

Suppose, for example, you're married and earn $75,000 in income. The long-term capital gains tax rate for that income level is 0. You will pay no tax no matter how large your gain is.

Suppose you're married and have $90,000 in taxable income in the 15 percent threshold. You have a net capital gain of $100,000 and cannot take the primary home exemption. You would pay $15,000.

Ways to Reduce Taxes

If you technically don't qualify for the primary residence exemption because you had to sell the home early to take a new job or for health reasons, you may still be able to exclude some gains. The IRS allows some exclusions based on "unforeseen events."

Even if you still can't gain an exemption or if you anticipate your gains to exceed the exemption, you can still reduce your taxes. Because taxes are on net capital gains, you can reduce your taxes by keeping careful records and receipts of all the improvements you made to the property.

For example, suppose you're single and bought the home for $300,000. Now, you are selling it for $700,000, meaning a gross capital gain of $400,000. If you qualify for the primary residence exemption of $250,000, $150,000 of your gross capital gain is potentially taxable. If your capital gains tax rate is 15 percent, that would be $22,500. However, if you provide accurate documentation for improvements on the home that totaled $100,000, then your net capital gains would only be $50,000, and your tax payment now would be reduced to $7,500.

You also could reduce your taxable capital gains by offsetting them with capital losses from previous years.

Selling your home is a major financial transaction. Understanding the tax rules, or consulting with a tax specialist, before you sell can help you avoid giving the IRS any larger share of the gains than you have to.

For informational purposes only. Always consult with an attorney, tax, or financial advisor before proceeding with any real estate transaction.