If you sell your home, you can deduct up to $250,000 in capital gains tax, or up to $500,000 for married couples; however, there is a lot of fine print that can help or hurt you.
You’re undoubtedly aware that if you sell your house, you may deduct up to $250,000 of the capital gain from your taxes. The exclusion for married couples filing jointly is $500,000. Unmarried people who own a home together and meet the tests outlined below can also be excluded. To be eligible for the full exclusion, you must have owned and lived in your home as your primary residence for at least two of the five years preceding the sale (this is called the “ownership and use test”). You are only allowed to use the exclusion once every two years.
Even if you do not meet this test, you may still be eligible for a full or partial tax break in certain circumstances. In this section, we’ll go over the most important options for taking advantage of the exclusion or even qualifying for it at all.
Is your gain on sale low enough to qualify for the tax exemption?
Many people mistakenly believe that their gain is simply the profit on the sale: “We bought it for $100,000 and sold it for $650,000, so that’s a $550,000 gain, and we’re $50,000 over the exclusion, right?”. It’s not that straightforward; which is a good thing, because the tiny print might really work to your favor.
Your profit is calculated by subtracting the selling price of your home from:
Closing costs, selling costs, and your tax basis in the property are all deductible.
Deductible closing costs include mortgage points or prepaid interest and your prorated share of property taxes.
Real estate broker commissions, title insurance, legal expenses, advertising charges, administrative costs, escrow fees, and inspection fees are examples of selling costs. (See When Home Sellers Can Use Sale Expenses to Reduce Capital Gains Tax.)
Your property’s basis is its original purchase price plus purchase expenditures plus the cost of capital improvements, less any depreciation and casualty losses or insurance payments. (See Tax Reasons to Keep Good Home Improvement Records.)
Assume you and your spouse purchased a home for $100,000 and sold it for $650,000. You’d made $20,000 in home upgrades, spent $5,000 preparing the house for sale, and paid at least $25,000 in commissions to the real estate agents. You would owe no capital gains tax if you combined the capital gains tax exclusion with those charges.
See IRS Publication 551, Basis of Assets, and search for the part on real property for further details.
Do you meet the ownership and use test for the capital gains tax exclusion—or are you eligible for an exception?
Let’s assume you haven’t resided in your house for two years out of the past five. However, you may still be entitled for a partial exclusion of capital gains if:
You sold because of a job shift, your doctor advised you to relocate for your health, or you’re selling through a divorce or due to other unanticipated events such as a death in the family or numerous babies. (“I changed my mind about living here”) is insufficient.
In such a circumstance, you would get a part of the exclusion depending on the time you spent there throughout the two-year period. To figure it out, divide the number of months you lived there prior to the sale by 24.
For example, if an unmarried taxpayer resides in her house for a year and then sells it for a $100,000 profit due to an unforeseeable occurrence, the full amount may be deductible. She may claim half of the exclusion, or $125,000, since she resided in the residence for half of the two-year period. (12/24 x $250,000 = $125,000.) That pays for her full $100,000 gain.
Stays in nursing homes and the Ownership and Use Test
The ownership and usage criteria is reduced to one out of five years in your own house before joining a nursing home for those who have relocated there. Furthermore, time spent in a nursing home counts toward ownership time and usage of the dwelling. For example, if you lived in a house for a year and then spent the next five in a nursing home before selling it, you would be eligible for the full $250,000 exclusion.
The Ownership and Use Test, as well as Marriage and Divorce
Married couples filing jointly may exclude up to $500,000 in gain if the following conditions are met:
Both spouses meet the use test, neither spouse has sold a home in the last two years, and neither spouse has sold a home in the last two years.
Separate dwellings. If a married couple owns and occupies a separate residence and files jointly, each can exclude up to $250,000 in gain when they sell. In addition, if it’s a new marriage and one spouse sold a home within two years of the marriage (thus disqualifying themselves from the exclusion), the other spouse could still exclude up to $250,000 in gain on a home owned before the marriage.
Tax breaks twice? In rare cases, a new marriage might also double the tax advantage. Assume a single individual sold his primary house on October 1st and made $500,000 in profit. Assume he and his girlfriend have been living in the home for two years (although her name isn’t on the title), so they both meet the usage criteria. If they marry before midnight on December 31, the same year, they may file a combined return for that year and deduct the whole $500,000.
Divorce and tax benefits. Divorced taxpayers may deduct their former spouse’s ownership and usage of their house. Assume that after a divorce, the woman is permitted to remain in the husband’s home until she sells it. He’s had the house for 18 months. When the transaction is completed, the pair will divide the money 50-50.
If the woman sells the house after nine months, she may add her ex-ownership husband’s to fulfill the two-year ownership requirement. In addition, the husband may include his ex-continuous wife’s use of the house to complete the two-year usage requirement. Each has the right to keep $250,000 of the selling revenues. Widowed taxpayers may additionally deduct their dead spouse’s ownership and usage.
Exclusion for a Second Home Used as a Primary Residence
If you sell a house that you utilized as a vacation or rental property and as your permanent residence on alternate occasions, you are only eligible for the percentage of the capital gains exclusion that corresponds to the period of time you actually lived there as your primary residence. (The remainder of the time is referred to as “non-qualifying usage.”)
It’s worth noting that the calculation spans more than five years, going all the way back to January of 2009. (when the relevant legislation was passed). Furthermore, if you never used the house as your principal residence during the five years before the sale, you are likely unable to use the exception. (It should come as no surprise that this regulation was designed to raise greater tax revenue to offset certain other tax cuts.)
Depreciation and Home Offices: A Tax Advantage
The capital gains tax exception does not apply to dwelling depreciation allowed after May 6, 1997. If you are in a high tax bracket and want to dwell in your house for an extended period of time, depreciation deductions for a home office are quite important right now. If so, you should rethink utilizing a section of your home as an office since all depreciation deductions would be taxed at 25% when you sell the property.
A married couple sells a $100,000 property with an adjusted basis (purchase price + capital upgrades) for $600,000. They had claimed $50,000 in depreciation deductions for a home office throughout the years.
The asking price is $600,000
$100,000 Adjusted Basis
Gain taxable = $500,000
The $450,000 gain is tax-free; the $50,000 depreciation deduction is subject to a 25% capital gains tax.
Can You Split Big Gains With a Co-Owner to Avoid the Exclusion?
If you anticipate large profits from the sale of a home—more than what may be deducted from taxes—you should think about how to share ownership of the home.
Assume a couple owns their home with their adult son (perhaps because they’ve given him a stake). If the son passes the ownership and usage standards for one-third of the property, he may sell his portion for a $250,000 gain without being taxed. His parents may sell their stake for $500,000 and avoid paying taxes on the whole $750,000 gain.
How Much Capital Gains Tax Do You Have to Pay on Taxable Gain?
If some or all of your gain on the sale of your home is taxable, you must pay capital gains tax on the gain. If you own your house for more than a year, these rates are lower than personal income tax rates. If you held the residence for less than a year, you must pay tax on the gain at your regular income tax rate.
Long-term capital gains are taxed at three different rates: 0%, 15%, and 20%. The rate you’ll pay is determined on your tax filing status and total taxable income. Most people pay a 15% capital gains tax. However, if your income is low enough, you will pay no capital gains tax.
If your entire taxable income, including your taxable capital gain, falls between the 10% or 12% personal regular income tax categories, you pay no capital gain tax. You pay a 15% capital gain tax if your total taxable income falls into the 22%, 24%, 32%, or 35% personal income tax categories. If your income puts you in the top 37% tax band, your long-term capital gains are taxed at 20%. a maximum of $250,000.