Selling your home is exhausting and expensive enough without the stress of surprise taxes and fees.
When putting your house on the market, taxes are inevitable. But there are few strategies that can help you hold on to more of your money.
As home prices continue to surge, here’s how to minimize how much you pay on your profits — also called a capital gains tax.
What is a capital gains tax?
A capital gains tax is a fee that you pay to the government when you sell your home, or something else of value, for more than you paid for it. For example, if you bought a house years ago at $200,000 and sold it for $300,000, you’d pay a percentage of your $100,000 profit — or capital gains — to the government.
When you make money from selling a house or property, your capital gains tax depends on whether you lived in the house and how long you lived there.
Short-term capital gains
In general, you’ll pay higher taxes on property you’ve owned for less than a year. This is because short-term capital gains are taxed at the same rate as ordinary income. In 2017, that rate is between 10% and 39.6% of your profit, but most people pay around 25%.
Long-term capital gains
With long-term capital gains, you get the benefit of a reduced tax rate that typically doesn’t exceed 20%. If you’re selling a residence or investment property you’ve held on to for at least a year, you’ve effectively lowered your capital gains tax.
Does the capital gains tax apply only to real estate?
No. The IRS can take capital gains tax on anything you sell that makes a profit, including car and other investments, like stocks and bonds. (Most retirement accounts, however, allow you to defer paying taxes on gains until you’re eligible to withdraw money.)
If the price has gone up since you purchased an asset and you plan to sell it, you’ll typically pay capital gains tax on the profit.
Is my primary residence exempt from capital gains tax?
Yes. The IRS allows you skim up to $250,000 off the profit of a primary residence when calculating capital gains tax. That amount jumps to $500,000, if you’re married.
You can typically take advantage of this exemption if you meet three requirements:
You’ve owned your home for at least two years in the five years before you’ve looked to sell it.
Your home was your primary residence for at least two years of that same five-year period.
You haven’t taken a capital gains exclusion for any other property sold at least two years before this current sale.
Staying in your home longer than two years might help you qualify for an exemption. Even if it takes three years to sell it after you move, you could still avoid capital gains tax if you lived in the home for at least two years.
How much will I have to pay?
Most taxpayers miscalculate their capital gains by simply subtracting the purchase price from the selling price. But under the tax code, “purchase price” and “selling price” are much more.
Your purchase price — or “cost basis” — is what you paid for the house or property plus all the taxes and fees you paid when you bought it, typically from 2% to 5% of the cost. You can also include money spent on projects that added value to the property, like that extra bathroom or garage improvements.
On the other end of your investment, your selling price is what you sell your property for minus any commission or closing fees you pay to sell it.
Let’s say that years ago you paid $200,000 for a house. At that time, you paid $8,000 in taxes and closing fees. Since then, you’ve made $30,000 in improvements. In this case, your cost basis is $238,000.
Original purchase price
PLUS taxes and fees at time of purchase
PLUS added value
EQUALS cost basis
You’ve now sold this home for $450,000. To calculate your taxable profit, you’d subtract your cost basis from the price you sold it for.
LESS cost basis
EQUALS taxable profit
Your taxable profit on your recent sale is $212,000. And because you bought the home more than two years ago, you can walk away with your $212,000 tax-free.
How can I reduce capital gains tax on a property?
If your property isn’t exempt from the capital gains tax, here are a few strategies to minimize or reduce it.
Live in the property for at least 2 years.
To get around the capital gains tax, you need to live in your primary residence at least two of the five years before you sell it.
Note that this does not mean you have to own the property for a minimum of 5 years, however. Once you’ve lived in the property for at least 2 years, you’d reach capital gains tax exemption.
Plan to sell a property after you’ve experienced capital losses.
If you’re going through a period in which you’re producing less income than usual, it could be a good time to sell a property. Because your tax rate factors in your income, you can take advantage of a reduced rate.
Let’s say that your spouse leaves her job to pursue studies. Prior to her resignation, your two-income household put you in a higher tax bracket that could mean a capital gains rate of 15%. With your drop in income, you’re now in a lower tax bracket — which means fewer taxes on any home sale during this period.
Track your home improvements or selling expenses.
Don’t miss out on claiming all value you added to your house while living there. Keep track of how much you spend on improvements and upgrades to your property, and reflect that amount in your ultimate cost basis. You’ll need records and receipts when submitting your taxes.
Turn your primary residence into a rental.
Renting your property can be a solid way to cover your mortgage while you live elsewhere. But to be exempt from the capital gains tax, you’ll need to limit how long you rent it. After three years, it’s considered an investment property.
Are there specific exemptions for investment property?
Yes. Investors can look to Tax Code Section 1031 to profit on business or investment properties without paying capital gains tax.
Section 1031 allows you to trade “like-kind” properties to avoid paying taxes on the initial profit. These like-kind properties must be similar: You can trade a retail space for another retail space, but you can’t trade a retail space for a rental property.
If the value of one property is greater than the other, you can add cash to the deal. The person who owns the property of lesser value can pay any difference at the time of sale.
Can I avoid the tax by moving into my investment property?
Yes. If you live in your property for at least two years, it changes the nature of your property from an investment property back to your primary residence. You’re then eligible for the capital gains tax exemption of up to $250,000 (or $500,000 if you’re married).
Say you live in New York City with your spouse. You decide to sell your place in the city, where you’ve lived for the past two years, and move into your vacation home upstate. Since your city apartment was your primary residence, you take your $500,000 profit tax-free.
Your move upstate doesn’t have to be permanent. If you want to ultimately move back to the city, stay in your vacation home at least two years. After two years, that property becomes your primary residence, and you can sell it and pocket another tax-free profit of up $500,000.
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Homeownership often comes with the headache of ultimately selling your home. By knowing more about the intricacies of the capital gains tax, you could line up your sale to maximize the profits you make on your home or investment property. And save a big headache at tax time.
Frequently asked questions
Yes. How you intend to use your profits doesn’t factor into the calculations of your taxable amounts after the sale. If you’ve made a profit, that profit is subject to capital gains tax.
No. Capital gains are broken down into short-term capital gains and long-term capital gains. Short-term capital gains are taxed at the same rate as your ordinary income, whereas long-term capital gains come with reduced rates of 0% to 20%.
You report your capital gains by filing with the IRS Form 1040 Schedule D — Capital Gains and Losses.
Yes, but you’re limited as to how much of your losses you can deduct. Talk to a tax advisor or other professional for specific deductions for your losses.
Aliyyah Camp is a writer and personal finance blogger who helps readers compare personal, student, car and business loans. Aliyyah earned a BA in communication from the University of Pennsylvania and is based in New York, where she enjoys movies and running outdoors.
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