For many homeowners, the largest asset they own is their home. At some point, some homeowners may decide to sell their homes, whether that's to relocate somewhere else, upgrade to a larger home, or help finance retirement.
There are significant tax code implications that could impact how much of the net proceeds you end up with after the sale and what the potential tax liability may be on the sale. Let's take a look at how the newest tax laws affect you if you decide to sell your home.
- Selling a home is a major life milestone that may come with a large tax liability.
- Qualified single taxpayers can generally exclude $250,000 of profit when considering capital gains while couples who file joint returns can exclude $500,000 of profit.
- The taxpayer must have lived in the home for at least two of the previous five years and have not taken the exclusion in the past two years in order to qualify.
- There are a number of exceptions to these qualifications and taxpayers may be eligible for a partial exclusion.
- There are opportunities to increase your cost basis to reduce your tax liability after the sale of a home.
The Old Rules
Sellers could previously defer capital gains taxes on all past profits. This deferral could be made on any size profit as long as they met the following two requirements:
- The seller purchased a replacement home that cost more than the amount received for the home that was sold.
- The seller purchased the replacement within two years before or after the date of the sale.
For instance, suppose someone bought a home for $200,000 and sold it five years later for $300,000. Under older rules, you would have a potential capital gains tax liability on the $100,000 profit.
Assume you used the profit to purchase a new house for $325,000 one month after the sale. Because your purchase price was greater than net proceeds and because your new purchase occurred within an acceptable timeframe, your tax liability would potentially be deferred and used to offset future returns.
Under the previous rules, homeowners could defer any gains from a home sale provided the proceeds were rolled over to purchase a new principal residence of equal or greater value within two years. In addition, a seller who reached age 55 could permanently exclude up to $125,000 in profits without buying another home. These provisions were repealed in 1997 when the new rules were implemented.
A lot has changed since the 16th Amendment to the Constitution was enacted in 1913. This amendment provided Congress the power to levy taxes on income and capital gains.
The New Regulations
The Taxpayer Relief Act of 1997 took effect on Aug. 5, 1997. The act did away with the continual unlimited deferral of profits and replaced it with capped exclusions. The capital gains rules around the sale of a principal residence allow single taxpayers to exclude $250,000 in profits on their home's sale. Married couples who file jointly can exclude $500,000 from their taxable income.
Age is not a factor, and you do not have to buy a replacement home. After you take the exclusion, you could buy a less expensive home or revert back to being a renter. Better still, the Internal Revenue Service (IRS) allows homeowners to use the exclusion every time they sell their principal residence.
There are two rules that homeowners must meet to qualify for the current deferral rules:
- They must have owned and used the home as their principal residence for at least two out of the previous five years. These two years do not need to be consecutive.
- They cannot have used the exclusion during the preceding two years.
What if this couple only lived in the house 1.5 years before selling it? Because the property does not qualify for capital gains exclusion, 100% of profits are taxable.
Like many other pieces of tax legislation, there are many exceptions and considerations to the rules. Be sure to consult a tax advisor if you're unsure whether you qualify for capital gains deferral.
A home sale does not qualify for any exclusion if the property was acquired through a like-kind exchange within the past five years. In addition, the homeowner must have owned the home for at least two of the past five years leading up to the sale. Keep in mind that only one spouse in a married couple has to meet this requirement.
The residence test is needed to determine whether the home qualifies as a primary residence. The homeowner must have used the residence for an aggregate of 24 months within the previous 60 months. Vacations or short absences away from the residence count as time lived in the house as do specific conditions around living in a care facility.
Exceptions to Eligibility
There is an extensive list of exceptions to the eligibility requirement for capital gains exclusions. These exceptions include but are not limited to:
- Sales or ownership transfers as part of divorce settlements or separations
- Sales due to the death of a spouse during the ownership of the home
- Sales including vacant land
- Taxpayers whose previous home was destroyed or condemned
- Taxpayers who were service members during the ownership of the home
There are situations where a taxpayer is eligible for a partial exclusion if the home sale was related to work, health, or an unforeseeable event.
- Work-Related: The taxpayer must have transferred to a new job at least 50 miles away from the home than the old work location. A partial exemption is also granted if the taxpayer did not have a previous work location but the new job was at least 50 miles from their home.
- Health-Related: The taxpayer must have moved to obtain specific medical care for themselves or a family member. A partial exemption is also granted if a doctor recommends a change in residence due to underlying health conditions.
- Unforeseeable Events: The taxpayer must have experienced an uncommon event during the time they owned and lived in the house. The list of eligible events includes but is not limited to the home being destroyed, the death of a taxpayer, a taxpayer giving birth to multiple children during the same pregnancy, or divorce.
Publication 523 contains a section called Other Facts and Considerations. Even if you don't meet some of the requirements above, the IRS left the door open by noting that "even if your situation doesn't match any of the standard requirements described above, you may still qualify for an exemption."
Reducing Your Tax Liability
Although avoiding tax on a $250,000 ($500,000 for joint tax filers) profit is significant, it might not be enough to totally offset some sellers' gains. There are a few things you can do to increase your cost basis and reduce your tax liability.
Go back through your records to find out if you had other allowed expenses, including:
- Settlement fees or closing costs when you bought the home
- Real estate taxes that the seller owed but for which you paid and were not reimbursed
- Home improvements, such as a new roof or room addition
If your property simply does not qualify for a capital gain exclusion as it was not your principal residence, there is also the potential for tax savings through a 1031 exchange.
Examples of Capital Gains on Home Sale
Here's a hypothetical example to show how the sale of a home can impact your tax liability.
Let's say a married couple bought their home eight years ago for $200,000 and lived in it exclusively ever since. The couple is now ready to move into a larger home in a less expensive part of the country. The couple sells their home for $450,000 and acquires a new one for $400,000. Because the couple files their taxes jointly, they qualify for the capital gains exclusion and have no tax liability on the $250,000 profit.
Assume the same situation above, but the couple sells their home for $1,000,000. The couple qualifies for a $500,000 capital gains exclusion if they file jointly. However, the total profit on the house is $800,000 ($1,000,000 sale price - $200,000 purchase price). Therefore, the couple must recognize capital gains taxes on $300,000 ($800,000 total profit - $500,000 exclusion).
Do I Pay Taxes When I Sell My House?
If you qualify for a capital gains exclusion, all or a portion of the profit you make from selling your house may be tax-free. To qualify, you must have lived in your house for two of the past five years and meet other IRS requirements.
What Are Capital Gains?
Capital gains are income earned not through ordinary income like salary or wages. Capital gains refer to the profit generated by the sale of an investment greater than the cost basis of that investment. The IRS has many rules around how capital gains are taxed, which capital gains are exempt, and what different tax rates are.
How Can I Avoid Capital Gains?
The most strategic way to avoid capital gains is to increase your cost basis. The IRS has specific rules that benefit taxpayers. For instance, some inherited investments have a cost basis of fair market value at the time of receipt. Alternatively, taxpayers can make sure they account for all allowable costs as part of their acquisition. This includes allowable fees, taxes, or commissions.
What Are Capital Gains Tax Rates?
Capital gains tax rates depend on whether the profit is classified as short-term or long-term. Short-term capital gains are always taxed at your ordinary tax income level. This means you are taxed at the same rate as your salary or wages.
The long-term capital gains tax rate are as follow:
- For 2023 for single taxpayers earning up to $44,625 ($47,025 for 2024) or couples filing jointly earning up to $89,250 ($94,050 for 2024) was 0%.
- For 2023, the 15% rate applies to single taxpayers earning up to $492,300 ($518,900 for 2024) and couples married filing jointly earning up to $553,850 ($583,750 for 2024).
- For both 2023 and 2024, the highest earners are taxed at 20%, though specific assets like collectibles may be assessed at even higher rates.
The Bottom Line
Selling a home is a major life milestone. It will likely have a major impact on a taxpayer's finances and may result in a larger-than-expected tax liability. Though the rules have changed around capital gains recognition, there are plenty of opportunities to capitalize on tax exclusions, deferrals, or exemptions in the process of selling a home.
Correction—Nov. 18, 2023: A previous version of this article misstated that the old rules allowed the gains from home sales to be wiped out for beneficiaries of deceased homeowners.