What to Know About Capital Gains When Selling a Home

Selling a home can mean an unexpected tax-free windfall of up to a half-million dollars under certain circumstances. The best part is that taking advantage of the capital gains tax exemption is not a one-time opportunity. However, specific rules must be followed, and a homeowner must be diligent about record-keeping and timing in order to take advantage of the tax-free opportunities.

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

The Sales Tax Home Exemption

Under US tax law, the profit earned upon the sale of any asset that has increased in value is subject to a capital gains tax. The rate is variable, depending on circumstance and individual tax filing status. In specific, well-defined situations, taxpayers can claim an exclusion or exemption, relieving them of the responsibility to pay any tax. Selling a primary residence is one of those situations. Here are the rules:

The Internal Revenue Service (IRS) has, since the passage of the 1997 Taxpayer Relief Act, allowed an exemption of $250,000 for an individual or $500,000 for a married couple filing jointly on capital gains. The following requirements apply:

• The exemption can be claimed only for a principal residence;
• The exemption can be claimed only for property owned for at least two of the last five years;
• The claimant(s) must actually have occupied the home for two of the last five years (with allowances for military, disabled owners, and certain other situations);
• The exclusion can be claimed only once in two years immediately preceding the sale;
• The home’s purchase was not part of a 1031 exchange investment during the past five years;
• The owner is not subject to expatriate tax.

What Else You Must Consider

In general, capital gains tax is relatively easy to understand. The IRS recognizes two types of capital gains: short-term and long-term. The rates and the reporting rules differ, but in all cases, tax is paid on the difference between the actual cost basis of the asset and the selling price.

Short-term capital gains are taxed as regular income, so what you’ll owe depends on your income tax bracket. Long-term capital gains, however, are taxed at a lower rate and vary based on income level, from zero to 20 percent of the “adjusted gain.”

Tax is levied on the difference between the asset’s cost basis and the selling price. It is payable in the tax year following the sale. It doesn’t matter whether the asset is a stock with a realized gain of $2,000 or a home with a gain of $200,000.

Cost basis is defined as the initial purchase price plus the cost of all improvements. The selling price is the actual sales price minus all costs associated with the sale, including a real estate agent’s commission and closing costs.

The timeline is important. The two years of required residency do not have to be consecutive, but a taxpayer must have records to substantiate the claim of primary residency. Typically, that is easy. Owners of second homes and vacation property can sometimes qualify for the exemption by maintaining detailed records, but the advice of a tax professional is recommended.

How Capital Gains Tax Works in Real Estate

Example 1

A married couple owns a home in New Mexico and a vacation cottage in Maine. They live most of the year in New Mexico, but spend summers in Maine. After a few years, they decide to sell the house in New Mexico and move to Maine full-time.

Assuming they owned the New Mexico property for several years, any profit generated by the sale up to $500,000 would fall under the capital gains exclusion. The couple would not be taxed unless the profit exceeded that total. Even though they spent every summer in another place, they could easily show that they lived in the home for a total of two years or more.

Example 2

A little more than two years later, that same couple decides that Maine winters are not to their liking. They are considering selling the home and moving to a warmer climate. Once again, they might be able to qualify for a capital gains exclusion on the property because it would meet the tests of:

1. Primary residence for two years;
2. Owned for at least two years;
3. No capital gains exclusion was claimed within the previous two years.

More Details About Capital Gains Taxes

There has traditionally been some tax relief provided for homeownership gains. Before the 1997 tax reforms, an “Over 55” exemption offered one-time relief for homeowners nearing or at retirement age. The Act broadened the capital gains tax exclusion for homeowners to include all ages and removed the limitation of the one-time claim.

Although there is some possibility for misuse of the authorized capital gains exclusion, it is considered one of the primary benefits of home ownership. Even though the initial purchase price of a home may be high, most owners can look forward to selling for a higher price after only a few years based on normal appreciation. And they can also sell their home at a profit without fearing a substantial tax bill.

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

Updated December 2023