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Capital gains from the sale of your home can lead to a huge tax bill. When you sell a capital asset like a stock or property for a profit, the IRS wants a piece of the money you make.
It’s called the capital gains tax and can be one of the most onerous parts of your tax bill.
Fortunately, the IRS does have a special set of rules that apply to home sales, and depending on your situation, you may be able to reduce or eliminate your capital gains tax when selling your home.
Knowing Your Basis
Your home-sale profit is what’s left after you subtract the cost basis from the selling price.
If you bought or built the home, the basis is your cost, including settlement fees and closing costs.
For example, if you paid $300,000 for a home, including settlement amounts, legal fees, and closing costs, and later sold the home for $400,000. Your capital gain basis would be $100,000.
The basis is fair market value if you obtained the home as an inheritance, as a gift, in a trade, or from a spouse. Inherited homes are usually valued as of the day the previous owner passed away.
The IRS discusses determining your basis in Publication 523, Selling Your Home.
Two of the most popular strategies to avoid or lessen paying a capital gains tax involve raising your home’s cost basis or using the exclusion threshold.
Raising Your Cost Basis
The IRS allows you to raise your basis by the cost of any capital improvements made to the home. A higher basis lowers your profits, lowering your tax liability.
Capital improvements are additions, remodels, and other long-term upgrades. For example, spending $25,000 to upgrade your kitchen would raise your cost basis by $25,000.
Regular repairs and maintenance don’t qualify.
You can use home equity debt through a home equity loan or home equity line of credit (HELOC) to fund these improvements. Since your home has appreciated, you should have sufficient equity to support the financing.
If you want to get the improvement projects done quickly and sell the home fast, look into a HELOC; they’re easy to obtain and have low or no closing costs. If you have more time and aren’t sure when you will sell the home, consider a home equity loan because it’s not subject to interest rate volatility.
Either way, select a debt product that doesn’t have prepayment penalties.
When you take out either of these debt instruments, only the amount you use for home improvements raises your cost basis and potentially lowers your capital gains tax. You will not realize this tax benefit if you use a home equity loan or HELOC for other purposes.
The amount of your home equity loan is HELOC by itself and has no bearing on the cost basis of your home unless you use the funds in a way that qualifies. If you used part of the loan to make improvements, the improvements add to your cost basis and will reduce your gains, but that is true of all improvements, no matter how you pay for them.
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Using the Exclusion Threshold
Under the Taxpayer Relief Act of 1997, sellers can qualify for a capital gains exclusion if the home they are selling has been their principal residence for 24 months of the five years leading up to the closing date of the sale. The 24 months do not need to be consecutive to qualify.
This is sometimes referred to as the 2-in-5 Rule.
If the capital gains do not exceed the exclusion threshold of $250,000 for single people and $500,000 for married people filing jointly, the seller does not owe taxes on the sale of their house. This exclusion can only be used once every two years on the sale of a primary residence.
If you are married and made $400,000 on the sale of your primary residence, you could use the exclusion and pay no capital gains tax. However, if you sold that same residence for a $600,000 profit, you would be on the hook for paying a capital gains tax on the excess, or in this case, $100,000.
The exclusion rule allows you to convert a rental property into a principal residence because the 24-month residency requirement does not need to be fulfilled in consecutive years, just cumulative months. That means if you bought a home and rented it out for three years but then lived in it for two years during those five years, it would qualify for the exclusion.
Widowed taxpayers may be able to increase the exclusion amount from $250,000 to $500,000 if they sell their home within two years of the death of their spouse and haven’t remarried at the time of the sale. They must also meet two-year residence requirements and have not taken the exclusion on another home sold less than two years before the date of the current home sale.
Other Capital Gains Rules to Note
The rules regarding capital gains taxes are complex and lengthy. However, here are some important points to note as a starting point for growing your knowledge on this subject.
Capital losses from other investments can be used to offset the capital gains from the sale of your home. Significant losses can even be carried forward to subsequent tax years.
Improvements necessary to maintain the home with no added value, have a useful life of less than one year or are no longer part of your home will not increase your cost basis.
If the home is a rental or investment property, you can use a 1031 Exchange to roll the proceeds from the sale of that property into a like investment within 180 days.
Capital gains aren’t taxed until they are realized by making them real (by selling the property for a certain price, since otherwise prices can go up or down, and until you realize the gain, it’s only potentially a gain).
Consult Your Tax Professional
This information is a general guideline of what you can expect regarding capital gains taxes when you sell your home. It’s best to consult with your tax professional to determine the most favorable strategy to minimize your tax burden when capital gains may be a factor.