What is Capital Gains Tax?
Are you considering selling your home? If so, it's important to understand how capital gains tax may apply, as understanding the basics of capital gains tax and how they apply to your situation can make it easier to navigate the home selling process and reduce your minimum potential tax liability. Be sure to familiarize yourself with these basic ins and outs of capital gains tax before selling your home.
What is Capital Gains Tax, and How is it Calculated?
A capital gains tax is a tax on the profit you make when you sell an asset that has increased in value. The amount of tax you owe depends on several factors, including the type of asset sold, your tax bracket, and how long you held the asset.
For example, let's say you bought a house for $200,000 five years ago and sold it for $500,000 today. Your capital gain would be $300,000, and you would owe capital gains tax on that amount less the exemptions discussed below.
How Does Capital Gains Tax Apply to Home Sellers?
Good news—many home sellers don't have to tangle with capital gains tax at all. If you're selling your primary residence, you may be exempt from paying capital gains tax on the sale. This is because of the "primary residence exclusion," which allows homeowners to exclude up to $250,000 (or $500,000 for married couples or those filing jointly) of capital gains from taxes.
Going back to our previous example, if you filed as a single person, you would subtract $250,000 from your $300,000 capital gain and pay tax on only $50,000. If you filed jointly, your exclusion of $500,000 would exceed your gain of $300,000, so you would owe no tax.
To qualify for the exclusion, you must have lived in your home for at least two of the past five years—though those years don't need to be consecutive. Some other conditions must be met as well, so be sure to consult with a tax professional to see if you qualify.
How Can You Reduce or Avoid Capital Gains Tax When Selling Your Home?
If you don't qualify for the primary residence exclusion, there are still some ways to reduce or avoid capital gains tax. For example, you may be able to take advantage of the "1031 exchange" provision, which allows you to defer taxes on capital gains by reinvesting the proceeds from your home sale into another property.
If you've made home improvements between the time you bought the house and the time you sold, you may be able to reduce the amount of capital gains factored into the tax. Capital gains are calculated by subtracting the "basis" from the sale value, and the cost of home improvements can be added to the basis to result in lower "profit."
Our example home was bought for $200,000 and sold for $500,000, leaving a capital gain of $300,000. If you had made $50,000's worth of upgrades before selling, you would add that to the basis of $200,000 for a total of $250,000, subtracting that from the sale price to leave a gain of $250,000. In this case, by adding in the home improvements and taking the primary residence exclusion, you'd go from owing tax on $50,000 to owing no tax.
Home sellers can also include things like fees and closing costs involved in the selling process in their basis calculations, so be sure to ask your tax advisor what costs you're allowed to include from your home sale.
When Is the Best Time to Sell Your Home to Minimize Capital Gains Tax?
There is no easy answer to this question, as there are a number of factors to consider. You'll need to weigh the potential tax liability against the reasons you want or need to sell your home. For example, if you're selling in order to downsize or move closer to family, the tax implications may be less important than the personal benefits of the sale.
If you're looking to maximize your profit, you may want to wait until your home has appreciated significantly in value. If you want to minimize your taxes, you'll want to keep a close eye on what prices homes are selling for in your area.
Your Real Estate Agent Can Help
A real estate agent with experience handling home sales can be a valuable resource throughout the selling process. Your agent can provide information on recent comparable sales in your area, which can give you a good idea of your home's value. Additionally, your agent can help you understand the tax implications of selling and assist you in finding a qualified tax professional to consult with.