Planning on selling? There’s plenty to consider, including whether or not you’ll potentially be subject to capital gains taxes.
Generally speaking, any profits that are made from the sale of real estate may be subject to capital gains taxes. The actual profit itself is considered “capital gains,” and the IRS may want a cut of those profits when it comes time to file your taxes in the spring.
But are capital gains taxes applicable to primary residences? Sure, real estate investors may have to pay a cut of the profits they make as part of their overall business. But are homeowners who are selling the properties they live in also subject to capital gains taxes?
Capital Gains Taxes on Primary Residences
This may come as a surprise to many, but the sale of primary residences may be subject to capital gains taxes, depending on the situation.
However, you may be eligible for a capital gains tax cut thanks to the Primary Residence Exclusion in Section 121 of the Internal Revenue Code. Thanks to this exclusion, homeowners who are selling their primary residence can exclude $250,000 of any profits from the sale of their property if they’re single, or up to $500,000 if the taxes are being filed jointly as a married couple.
The caveat is that you must have owned and used the home as your primary residence for a minimum of two consecutive years out of the five years before it is sold.
But that doesn’t necessarily mean that you have to have lived in the home first two straight years without a break. For example, it’s possible to live in and out of the home sporadically, as long as the total combined amount of time totals two years out of the previous five-year time frame.
If you were away for work or were on an extended vacation for a few months, for instance, any time that you actually lived in the home is included in the two-year requirement.
Further, even though you are allowed to use this exclusion more than once, you cannot have claimed it at any point in the previous two years.
Let’s say you purchased your home with your spouse in 2013 for $350,000 and owned and lived in it until you decided to sell in 2018 for $550,000. That’s a $200,000 profit, or “gain.” If you owned the house for at least two years and lived in it for at least two out of the last five years, you may not necessarily be subject to any tax implications.
A recent change to the capital gains tax exemption rule now also allows exemptions for special situations. For instance, you may still be eligible to exempt $500,000 even if your spouse has passed away, but you’d have to sell the property in two years after your spouse’s passing. The previous rule stipulated that the home would have to be sold within the same tax year that the spouse passed away.
What if You Don’t Meet the Requirements For Exclusion?
If it is determined by the IRS that you’re ineligible for exclusion from capital gains taxes and are indeed subject to paying, either all or part of the profits you make from the sale of your home may be taxable. At this point, you’ll have to determine the capital gains tax rate that will apply to you. h
Short-term capital gains tax rates. If you owned your primary residence for less than one year, you would be subject to a short-term capital gains tax rate. This is equal to your ordinary income tax bracket.
Long-term capital gains tax rates. If you’ve held onto your home for more than one year before selling it, you could be taxed at the long-term capital gains rate. That said, the exact rate that you will be charged will depend on your income tax bracket. Basically, the higher your income, the higher your tax rate. Many people may qualify for a 0% tax rate; it all depends on your income and filing status.
The Bottom Line
If you’re subject to capital gains taxes when you sell your home, you could be forking over hundreds of thousands of dollars to Uncle Sam come tax time. If you can swing it, taking advantage of the tax exemption makes a lot of financial sense.
Be sure to position yourself appropriately before you consider selling so you can take advantage of this tax exemption and save yourself a ton of money. Of course, speaking with a tax specialist will help you determine what you need to do to help avoid paying capital gains taxes if possible.