Tax Implications of Selling a Home

Want to know the tax implications of selling a home? Whether you’re planning to sell your primary residence, second home, or real estate property, it’s essential to be aware of the tax implications.

If you’re a first-time seller or a seasoned homeowner, understanding how the sale of your home affects your taxes is crucial to maximizing your profits and avoiding unnecessary liabilities. 

Now, let’s explore the key tax implications or considerations when selling a home, including capital gains, tax exclusions, potential deductions, and how to plan for the sale to minimize your tax burden.

Capital Gains Tax

Capital gains tax is the tax you pay on the profit you make from selling an asset, such as bonds, stocks, or real estate. When you sell a home, the IRS considers the difference between the selling price and your “cost basis” in the house (essentially, what you paid for it, adjusted for certain costs) as your capital gain.

For example, if you bought a home for $150,000 and sold it for $400,000, your capital gain would be $250,000 ($400,000 – $150,000). The higher the gain, the greater the potential tax liability. But here’s the good news: In many cases, you can avoid paying capital gains tax on a significant portion (or even all) of that gain due to special tax rules for home sales.

We have both short-term and long-term capital gains. Short-term capital gains in real estate are profits made from the sale of real estate property that you’ve held for a year or less. They are taxed as ordinary income or personal income (with a tax rate ranging from 10% to 37%).

On the other hand, long-term capital gains are profits made from the sale of real estate properties held for over a year. Long-term capital gains are taxed at lower rates, usually at a tax rate of 0%, 15%, or 20%, depending on what you earn.

To note – The higher the difference between the cost basis and the selling price, the bigger the tax you would need to pay.

The Home Sale Exclusion: A Valuable Tax Break

The IRS offers a special tax exclusion for the sale of a primary residence, which can reduce or eliminate your capital gains tax liability. Under current tax law, if the property you’re selling is your primary residence, you may qualify to exclude up to $250,000 on capital gains as a single person and up to $500,000 for married couples filing jointly from taxes.

Tax Implications of Selling a Home: Key Information and Requirements to Know

• Ownership and Use Test: You must have owned and occupied the home as your primary residence for at least two of the last five years before the sale. The two years don’t have to be consecutive.
• Frequency Limitation: The exclusion can be used only once every two years. If you’ve used the exclusion in the past two years, you cannot use it again for the current sale.
• Taxpayers who are not eligible to write off all of the taxable gains from their income must report the gain from their home sale when they file their tax return.
• For mortgage debt, taxpayers must report canceled or forgiven debt as income on their tax return.

How to Calculate Your Capital Gain

When calculating your capital gain, it’s important to consider your original purchase price and any improvements you’ve made over the years. The IRS allows you to adjust your basis in the home to reflect the costs of improvements, which can reduce your taxable gain.

Example of calculating capital gain:

• Original Purchase Price: $150,000
• Home Improvements: $30,000 (e.g., adding a new kitchen, bathroom remodels, roof replacement, etc.)
• Selling Price: $400,000

So, the capital gain is $400,000 – ($150,000 + $30,000) = $220,000

If you qualify for the full home sale exclusion, and you’re a single filer, you could exclude the entire $220,000 capital gain from your taxes.

Special Situations: Tax Implications of Selling a Second Home

Tax implications still apply to the sale of a second home. Second homes like rental properties, investment properties, or vacation homes are capital assets under IRS rules. However, capital gains tax exclusion doesn’t apply to the second home sale. You typically would be paying tax on capital gains at a rate of up to 20%, based on your tax brackets.

If you sell a second home or a property that you’ve rented out, any profit made from the sale may be subject to capital gains tax.

Potential Deductions When Selling a Home

While capital gains and exclusions dominate the tax conversation for home sellers, other deductions and credits could apply, depending on your situation. Some common tax benefits include:

1. Selling Costs: You may be able to deduct certain costs associated with the home sale. These can include:

•    Real estate agent commissions
•    Closing costs
•    Repairs or renovations made to prepare the home for sale
•    Advertising costs or staging expenses

These deductions can help reduce the overall capital gain you report to the IRS, as they are considered part of the cost of selling the property.

2. Mortgage Interest

If you’re still paying off your mortgage, any interest you paid during the year can be deducted from your tax return. Keep in mind that mortgage interest deductions are generally more relevant when you’re still living in the home, not when it’s sold.

3. Consider State and Local Taxes

While federal tax laws are an important factor, it’s also essential to consider state and local taxes when selling a home. Some states impose their own capital gains taxes, while others may offer additional home sale exclusions or deductions. For instance, in California, the state taxes capital gains as regular income, while in other states like Texas or Florida, there is no state income tax.

Additionally, you may be subject to local taxes, which vary by city or county. Check with your local tax authority to understand any regional variations that could affect your sales.

How to Minimize Your Tax Liability

To make the most of your home sale and reduce your tax burden, consider the following strategies:

1. Time the Sale

If you can, time the sale of your home to maximize the benefit of the home sale exclusion. For example, if you’ve lived in your home for two years, you may want to wait until the end of the third year to sell, ensuring you qualify for the exclusion. 

2. Keep Track of Home Improvements

Always document and save receipts for home improvements, as these can increase your basis and reduce your taxable gain.

3. 1031 Exchange for Investment Properties

If you’re selling a rental or investment property, consider utilizing a 1031 exchange to defer taxes while reinvesting the proceeds into another property. This strategy is most often used by real estate investors looking to avoid taxes while continuing to build wealth through property. 

According to the IRS, investors are required to identify a replacement property within 45 days of the sale and close the sale within 180 days.

Realize that proceeds from the sale of the property must be held in escrow by a qualified party. A qualified party or intermediary is an individual or company that sells a property on your behalf. They hold the funds from the previous property and use it to purchase a replacement property.

4. Consult with a Tax Professional

Buys Houses are not tax professionals.  Navigating property tax rules can be complicated. Consulting with a tax advisor or financial planner who understands your situation is always a good idea to ensure you’re taking advantage of every tax rule(s).

Conclusion – Tax Implications of Selling a Home

The tax implications of selling a home vary. For many homeowners, the home sale exclusion provides a significant tax advantage, potentially allowing them to avoid capital gains taxes on up to $250,000 ($500,000 for married couples). However, it’s important to keep track of your home improvements, understand the timing of your sale, and be aware of any state or local tax obligations that’s why you should seek a tax professional.

By understanding the tax rules, you can make the most of your home sale and keep more of the proceeds in your pocket. Whether you’re selling your first home or not, some tax knowledge can go a long way in ensuring the sale is a financial success.

If you need to sell your property fast, contact Buys Houses by filling out our contact form. Someone on our team will contact you soon.