Capital Gains Taxes on Real Estate Explained

Selling your primary residence is a significant milestone. Besides the emotional implications, it also has financial impacts, too. If you’ve been nervously Googling questions like, “Do I pay tax if I sell my primary residence?” or “How does the section 121 home sale exclusion work?”—rest assured, you’re not alone. Figuring out capital gains taxes on real estate can feel like trying to crack a safe without the code. Good news, though—this guide has the code.

Understanding capital gains tax (and how to avoid it) starts with knowing the tax exclusions available to you. We’ll also tackle some special cases, like inherited homes and properties in trusts, to help ensure your sale doesn’t lead to an unexpected tax bill.

What is the 121 Home Sale Exclusion?

Here’s your golden ticket to keeping Uncle Sam at bay! The Section 121 home sale exclusion allows homeowners to exclude a significant portion of their capital gains on the sale of their primary residence.

• For Single Filers: Up to $250,000 of your profit can be excluded from capital gains tax on your income tax return. 
• For Married Couples Filing Jointly: That exclusion rises to $500,000. 

This exclusion means less money spent on your annual income taxes and more to reinvest, save, or celebrate your next chapter.

Do I Qualify for the 121 Home Sale Exclusion?

This exclusion generally applies if you meet specific criteria. To unlock this exclusion, pass these three tests:

1. Ownership Test: You must have owned the home for at least two years out of the last five years before selling.
2. Use Test: You must have lived in the home as your primary residence for at least two of those five years.
3. Frequency Test: You can’t have claimed the home sale exclusion on another property within the past two years.

These rules limit the exclusion benefits for people using the property as their primary home—not those flipping houses for profit. Those properties will pay short-term gains tax.

However, what if you are a service personnel or involved with another governmental assignment that has caused you to live away from your primary residence? The five-year test can be suspended if the duty station was over 50 miles from your main home and you lived in government housing under government orders.

Calculating Capital Gains on a Primary Residence 

Now, about that all-important profit. Here’s how you calculate your gain and potentially your tax liability:

1. Start With Your Sale Price. This is the total amount your home sold for. 
2. Add to Find Your Adjusted Cost Basis. Your basis includes the original purchase price plus the cost of capital improvements, such as significant home renovations, new roofs, and new home systems like HVAC.

For example:

• Purchase Price: $200,000 
• Major Capital Improvements: $50,000 (new roof, kitchen upgrade, etc.) 
• Adjusted Basis: $250,000 

Now, subtract the sales price plus any real estate commissions and closing costs paid at the time of sale.

• Sale Price: $400,000 
• Total Closing Costs: 8% ($32,000)
• Gain: $400,000 – $250,000-$32,000 = $118,000 

If you’re a married or single filer, that $118,000 stays within the $250,000 exclusion limit, and congratulations—you owe zero taxes on the sale!

Now, what about if your profits go above $250,000 for single taxpayers or $500,000 for those married filing jointly? The long-term capital gains tax rates depend partly on your total taxable income and which income bracket you fall under. High-incomer earners could owe as much as 20%.

The only caveat is capital gains taxes are cumulative. If you’ve profited from other investment sales, it could lead you to owe Uncle Sam some money. That’s when consulting a tax professional and certified public accountant (CPA) becomes very helpful and a wise step.

Finally, you’ll pay short-term capital gains if your ownership doesn’t meet the two-year period or use test stipulation.

Special Cases and Situations That Trigger Taxes

Not everyone qualifies for the exclusion, and there are certain situations where capital gains tax might apply. Here are some scenarios that could mean part (or all) of your gain is taxable:

• Your Gain Exceeds the Exclusion Limit: If your sale profit exceeds the $250,000/$500,000 filing status thresholds, you’ll pay capital gains tax on the amount above the limit. 
• It Wasn’t Your Primary Residence: If you didn’t live in the home for two of the past five years, you’re unlikely to qualify for the exclusion, though some special exemptions may apply (more on below). 
• You Rented the Property or Claimed Depreciation: If you used your home as a rental or home office and claimed depreciation deductions, the IRS will tax the depreciation portion. Investment property is liable to capital gains taxes.
• You’ve Used the Exclusion Recently: If you claimed the home sale exclusion in the last two years, you’re not eligible again—at least not yet.

What If I Sold an Inherited Home? 

When selling an inherited home, the tax rules change a bit. While the Section 121 home sale exclusion generally doesn’t apply, there’s a silver lining called the stepped-up basis.

The stepped-up basis adjusts the home’s value to its fair market value at the time of inheritance rather than the original purchase price. For example:

• Inherited Basis (Fair Market Value at Time of Death): $300,000 
• Selling Price: $320,000 
• Gain: $320,000 – $300,000 = $20,000 

Instead of owing taxes on decades of appreciation, you’re only taxed on the $20,000 increase since you inherited it. This drastically reduces the potential taxes on capital gains!

Does Putting Your Home in a Trust Avoid Capital Gains Tax? 

It depends on the type of trust. If you place your primary residence in a revocable living trust, the tax treatment typically remains the same—you, as the grantor, maintain ownership for tax purposes and can still qualify for the 121 home sale exclusion. 

However, for irrevocable trusts, ownership transfers to the trust, meaning you may lose eligibility for the home sale exclusion. Before going down the trust route for estate planning, consult a financial advisor or estate attorney to weigh the tax implications.

What About Unforeseen Circumstances? 

Life happens; sometimes, you must sell your home before meeting those two-year thresholds. The IRS allows for partial exclusions in these cases, whether it’s a job relocation, health issue, or another major life change. The reduced exclusion on long-term capital gains is prorated based on how long you lived in the home.

For example, if you lived in the home for 12 months instead of 24 and met the criteria for a qualifying circumstance, you could exclude 50% of the standard limit amount ($125,000 for singles and $250,000 for married couples filing jointly on tax returns).

The tax code also makes exceptions in this five-year test period for those who serve their country and had to move as part of the service. In addition to military personnel, it includes those working extended duty in foreign service or intelligence work.

Reporting the Home Sale 

Form 1099-S reports all the proceeds from a real estate transaction to the IRS on your federal tax return.

If you sell or exchange a residence for $250,000 or less and provide a written certification confirming that the home was the principal residence, the gain from the sale can typically be excluded from gross income under Section 121. This means the exclusion covers the entire amount of the gain, provided all the requirements of Section 121 are met. For the seller, this certification ensures that the sale proceeds are handled efficiently without unnecessary tax obligations if the criteria for exclusion are satisfied. There’s no need to report the sale to the IRS.

When selling real estate above $250,000, further reporting the sale on your tax return is unnecessary if your entire profit falls within the exclusion thresholds. However, if part of your gain is taxable (profits above $250,000) or the property doesn’t qualify for the exclusion, you’ll need IRS Form 8949 and Schedule D to report the sale for tax purposes.

Understanding Capital Gains Tax 

Taxes on capital gains are part of life in the United States. For most homeowners, the Section 121 home sale exclusion means you won’t owe a long-term gains tax when selling your primary residence. Still, tricky situations like high-value properties, inherited homes, or properties in trusts require extra care. Accurate calculations and understanding exclusions can save you thousands.

If you’re planning to sell your home or are just curious about how capital gains affect real estate sales, don’t hesitate to ask a tax professional or financial advisor. You’ll be glad you did! Federal income tax brackets and tax rates change yearly, as does your income tax liability. Getting updated advice is smart.