If you’re looking to sell a home, one of your last thoughts is, “what will the tax bill be once this is over?” While it may seem like a tiny detail, selling at the right time could save you thousands in taxes.
While a primary residence can often be sold tax-free, rental and investment properties are subject to capital gains taxes. Keep reading to learn about the requirements for meeting the primary residence exemption and how to avoid a big tax bill when your home doesn’t qualify.
How do Capital Gains Taxes Work on Real Estate Sales?
The sale of a primary residence is usually tax-free as long as you’ve lived in the property for two years and meet the requirements set forth by the Taxpayer Relief Act of 1997. As a general rule, under the act, single filers can exclude up to $250,000 of profit from the sale of a primary residence, and married filers can exclude up to $500,000.
Let’s say you bought a home for $200,000 ten years later and sell it for $750,000; as long as you meet the exemption requirements set forth by the IRS, you are not on the hook to pay taxes on all $550,000 of profit.
If you are a single filer, you can claim a deduction of $250,000 and are only required to pay a long-term capital gains tax on the remaining $300,000. If you get married and file jointly, the deal gets even better; you can claim a $500,000 deduction on the sale of the house and will only be liable for paying long-term capital gains taxes on the remaining $50,000 of profit.
What is the 2-in-5 Year Rule?
In order to qualify for this tax exemption, the home must be your primary residence. To qualify as a primary residence, you must meet the requirements of the 2-in-5 year rule:
- You’ve lived in the home for two of the past five years (730 days or 24 months).
- The two years do not have to be consecutive. You can live in the house for two years and then rent it out for three.
The other factors that come into play include:
- You can only claim one house as your primary residence in a given year
- You can not have sold another “primary residence” within the past two years
In addition, if you are married and filing jointly, you and your spouse must meet the above criteria.
What is Adjusted Home Basis?
When you sell your home, you don’t necessarily pay taxes on the original purchase price versus the price it was sold for. There are certain instances where the cost basis of the home can change.
You receive a cost basis reduction anytime you receive a return on your cost. For example, if you bought a home for $250,000 but then received $100,000 from your home insurer due to flooding, the new cost basis of your home would be $150,000. However, if you sold your home for $500,000, you would be taxed based on the difference between the new cost basis of your home and the sale price.
Similarly, there are ways to increase the home basis, like major renovations. For example, if you spend $50,000 renovating your kitchen, then it would increase your home basis by that amount. The improvements you make must have added value, the useful life of at least one year, and still be part of your home when the property is sold to increase the home basis.
Home Basis When Inheriting a Home
If you are fortunate to have a home bequeathed to you by a loved one, then you may wonder how the home basis is determined. The house’s fair market value determines the home’s basis on the date that the owner died.
Therefore, if the owner bought the house for $60,000, but it’s worth $400,000 on the date of their death, then the home basis when you go to sell the property will be $400,000. However, if you move into the inherited house and live there for at least two years, it is eligible for the primary residence exclusion.
Taxes on Investment Properties
An investment property, also known as a rental property, is a property purchased for the sole purpose of making money. An investment property does not qualify for a tax exemption. Therefore, the profit from selling an investment property is subject to either short-term or long-term capital gains taxes.
How to Avoid Taxes Paying Taxes on Your House
If you don’t qualify for the primary residence exemption or simply have exceeded the exemption, there are still additional ways to avoid paying taxes. Two of the most popular include:
- Offsetting capital gains with capital losses. If you’re planning on selling your house, then that may be a good time to sell some of your other investments at a loss. The losses can offset taxes on profits made from the sale of your house.
- If you’re planning on selling an investment property, you might consider moving the profits from the sale into another investment property. Under the 1031 exchange, you are able to roll your gains from the sale of one investment property into a like investment as long as it’s done within 180 days.
Should I Get Tax Help When Selling a Home?
It’s essential to understand the tax rules surrounding the sale of a home, as even a small mistake can cost you thousands in taxes. Even licensed real estate agents make mistakes when closing on sales costing their clients a ton of money in taxes. Contact us to get the answer to any of your tax-related home sale questions and ensure that you don’t pay the IRS a penny more than you should.