How To Sell Your Home Without Paying Capital Gains Tax
Hanna KielarJanuary 11, 2020
The last thing you want to do is to have to pay capital gains on a home sale, especially if you need those funds to buy a new home, or are looking to downsize.
But what if I told you that there are a ton of ways to avoid taxes on a house sale and that once you understand the process, you will probably be able to avoid them with ease.
In this post today, I am going to go over what capital gains taxes are, guidelines to follow to qualify for an exemption and the times when you’ll be required to pay the tax.
What Is Capital Gains Tax?
The capital gains tax is essentially a tax on any gains you realize after the sale of an asset, like real estate, bonds, jewelry, coin collections, or stocks.
There are a few ways you could end up paying this tax on your home.
For instance, if you decide to sell your primary residence less than a year after moving in, you would be subject to a capital gains tax.
And there are also ways to avoid this tax; for example, if you sell your home after 2 years.
Some exclusions also allow you to avoid being taxed up to a certain amount.
When Is Real Estate Exempt From Capital Gains Tax?
Real estate becomes exempt from capital gains tax if the home is considered your primary residence.
According to the IRS, your primary residence is a home you have lived in for at least 2 of the last 5 years.
Keep in mind, however, that this exemption can only be used once every 2 years, and there is a monetary limit to these exemptions.
Capital gains on a home saleare exempt from taxation up to $250,000 for singles and $500,000 for married couples.
We discuss this in more detail below.
Capital Gains Tax Limits
Depending on your marital status, there are limits to the amount of capital gains tax on a home sale that you can exclude from being taxed.
Single – If you’re single, $250,000 of gains on the sale of a home are excluded from taxable income. This means that if you buy a home for $350,000 and 3 years later, you sell it for $550,000 the capital gain would be $200,000. This is under the $250,000 limit, so you wouldn’t pay any capital gains tax.
Married – If you’re married, $500,000 of gains on the sale of a home are excluded from taxable income. However, if you go above that amount, you’ll have to pay gains tax on anything above it.
For example, if you purchased a home 4 years ago for $600,000, and now you sell it for $1.2 million. Your gain would be $600,000, which is $100,000 above the $500,000 limit; therefore, you would have to pay taxes on that $100,000.
You don’t have to occupy the residence in consecutive years to qualify for the exemption, either.
For example: If you stayed in your home the first year, rented it out for 3 years, and stayed in it for the fifth year, you could still sell it without the capital gains tax.
When Is Real Estate Not Exempt From Capital Gains Tax?
There’s a thin line between being exempt and not being exempt from capital gains tax on the sale of your home.
This is because there are specific qualifications that can exclude home sellers from exempt status.
Now, most of these qualifications are aimed at house flippers. Still, according to the IRS,you will not qualify for the exemption if:
- You acquired the property through a like-kind exchange (1031 exchange) during the past 5 years.
- You are subject to expatriation tax.
- You haven’t owned your home for more than 2 years out of the last 5 years leading up to the date of the sale.
- You haven’t lived in the property for at least 2 years of the previous 5 years as well.
- You have sold a previous home and taken the exemption within 2 years of trying to sell another home.
Is My Second Home Exempt From Capital Gains Tax?
In general, you’re going to be on the hook for the capital gains tax of your second home; however, some exclusions apply.
If you purchase a second home, and you start using it as your primary residence, you’ll need to meet the residency rule still to qualify for the exemption.
Now, you might be thinking that you could just split time between the two homes and then sell them both as your primary residence to avoid capital gains on the sale of a second home.
However, you have to prove that the second home is your primary residence.
You also can’t get the exclusion if you have already sold a different house within 2 years of using the exclusion.
So, if your second home meets the 2 out of 5-year rule, then the amount of capital gains tax exclusion changes.
It will depend on the number of years you owned the house, and when the home became your primary residence.
It might be best to speak with a personal tax advisor to help figure out if you qualify for the exclusion on a second home before you sell it.
How Can I Avoid Capital Gains Tax On A Home Sale?
There are a few ways to avoid paying capital gains tax when you sell your home. We’ll break down the most straightforward:
Live In The House
As stated above, one of the most important factors for avoiding capital gains tax is to make sure you meet the residency requirement. You need to have lived in the home for at least 2 out of the last 5 years before you try to sell your home.
If you are a married couple filing joint taxes, then both of you must meet the residency requirement to qualify for the exclusion.
Keep Your Receipts
If you make changes to your house or spend money on the process of selling your home, you can add those expenses to the tax basis of your home.
There are instances when you can increase your tax basis and lower or altogether avoid capital gains tax.
Deducting Your Home Improvements From The Home Sale Profit
Making substantial physical improvements to your house, no matter how long ago you made them, allows you to add the cost of that improvement to your tax basis.
Home improvements you can use include:
- adding a new bedroom, bathroom or garage
- installing new insulation, pipes or duct work or even replacing walls and floors
- installing a new heating and air conditioning system
- installing extensive new landscaping, such as new lawns, new fences or retaining walls
- adding a new porch, patio or deck
- replacing driveways and walkways
- installing a new roof, windows, doors or new carpeting
- installing new built-in appliances
Just remember that you can’t use regular home repairs like cleaning the carpets in your list of home improvements.
Selling Expenses That Can Be Deducted From Your Home Sales Profits
You can also deduct any expenses related to selling your home from the sales price of your home, as long as they don’t physically affect the property.
These expenses can be:
- advertising or notary fees
- appraisal fees and attorney fees
- closing fees and document preparation fees
- escrow fees and mortgage satisfaction fees
- points paid by seller to obtain financing for buyer
- real estate broker's commission or recording fees
- costs of removing title clouds
- title search fees, and settlement fees
While most of these costs will be listed in the closing statement prepared by the escrow or bank, you need to keep track of your own receipts to make sure you avoid as much tax as possible.