Will you need to pay capital gains when you sell your home?

Overview: Will you need to pay capital tax when selling your home?

• Capital gains are the money you make, or profit, when you sell an asset, such as a home, and are taxed at a different rate than regular income if held for over one year

• Home sellers are eligible to exclude federal capital gains taxes on the sale of their primary residence on profits up to $250,000 for a single filer or $500,000 for joint returns as long as they owned and lived in their home for 2 of the past 5 years

• Home sellers are eligible for the capital gains tax exclusion on investment or rental properties if they lived in the property for a two-year period of time out of the last 5 years

Selling your house can be a joyous occasion as you move on to the next phase of your life. But before you move too far along, you need to understand the potential tax consequences of selling your home. A little tax planning could save you a lot of money on taxes.

You may not have to pay any federal income tax on your house sale thanks to a significant capital gains exclusion, but not everyone qualifies. Here's what you need to know about if you need to pay capital gains taxes when selling your home.

What is capital gains tax?

You generally have to pay capital gains taxes whenever you sell a capital asset at a gain. Although capital asset sounds like a fancy term, the IRS says it's pretty much everything you own, both in terms of personal items and investments. Capital gains refer to the money you make, or profit, on the sale of those assets or investments. 

Figuring out the details of capital gains taxes is a bit more complicated. First, figure out whether you sold the item at a loss or gain. To do this, you must calculate whether you sold an item for more than its basis.

Basis can vary from item to item, but it's typically the original purchase price. Sometimes, you can include money spent to improve the asset in the basis. This is the case for your house. If you build out your unfinished basement, those costs likely increase your basis. That said, standard repairs and maintenance, such as repainting the walls in your living room, would not.

After you figure out whether you have a capital gain from the sale of a capital asset (your house), you have to figure out which capital gains tax rates apply. You pay short-term capital gains tax rates if you keep the asset for a year or less. These rates are the same as the usual ordinary income tax rates you pay on your income, which could be as high as 35% depending on various state laws.

You get beneficial tax treatment if you hold an asset for more than a year. In this case, you pay long-term capital gains tax rates. These rates are much lower than ordinary income tax rates and can be as low as 0%. On the high end, long-term capital gains rates cap out at 15% for most people, but other higher rates can apply if you have a high income or sell certain types of capital assets.

Will you need to pay capital gains tax on your home sale?

If there weren't special rules, you would likely be stuck paying capital gains taxes on your home sale. Thankfully, you can take a large exclusion in certain circumstances to avoid paying capital gains taxes on hundreds of thousands of dollars of gains. The exclusion works differently depending on if the home is (or was) your primary residence or is (or was) an investment property.

If the home is (or was) your primary residence

Most people living in a principal residence qualify for a capital gains exclusion of $250,000 for single filers or $500,000 for married filing jointly filers. This could potentially allow you to get tax-free profit on the sale of your home of up to the amount allowed for your filing status.

To qualify for this exclusion, you must pass two tests:

• You must have owned the house for two of the past five years before the date of sale.

• You must also have used the home as your primary residence for two of the previous five years prior to the date of sale.

As with any tax situation, there are exceptions that may disqualify you. Double-check with a tax professional or by using the best tax software before assuming you qualify for this exemption.

If the home is (or was) an investment property

If you invest in real estate, you may have always held your investment properties as such and never lived in them. In this case, you don't qualify for the $250,000 capital gains exclusion.

However, you may still be eligible if you lived in the home before turning it into a rental property. As long as you meet the ownership and use tests for two of the last five years before selling the house, you normally still qualify for the exclusion. This even works if you're an investor flipping houses as long as you meet the tests.

Having an investment property complicates the calculation of the capital gains amount due to rental income real estate taxation rules. You may also have to pay a depreciation recapture tax when you sell your rental home. Contact your tax professional for more information.

And although there are some exceptions, for the most part, you will be eligible for this capital gains tax exclusion only once every two years.

Bottom line

Minimizing taxes is one of the keys to building wealth. You may not have to pay federal income taxes when you sell your home due to the $250,000 or $500,000 capital gains exclusion for qualifying homeowners. But if you have a gain that exceeds that amount or you don't pass the tests required to get the exclusion, you might still be able to lower your taxes in a different, but major way.

Carefully examine your time as owner of the home to see whether you can increase the basis in the home from the money you put into it. Home improvements generally increase your basis, whereas maintenance usually doesn't. You'll need documentation from the expenses, but every dollar you can add to the basis is one fewer dollar you'll have to pay capital gain taxes on.

This article is published for informational purposes only and is not intended to provide, and should not be relied upon for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors when preparing your tax returns.