It can feel great to get a high price for your home, but in some cases, the IRS may want a piece of the action. That’s because capital gains on home sales and other real estate can be taxable.
What is the capital gains tax on real estate?
When you sell your home for more than what you paid for it, you could be subject to capital gains tax on the profit. Capital gains tax rates are generally determined by three factors: your taxable income, your filing status and how long you had the property before you sold it.
However, some homeowners may be able to avoid paying capital gains tax on their profit because of an IRS exemption rule called the Section 121 exclusion (also known as the home sale tax exclusion).
How capital gains taxes on home sales work
Generally, the IRS allows people who sold their primary homes to exclude or exempt a certain amount of the profit from their reportable income.
Single filers and those married filing separately can exclude $250,000 of capital gains and those married filing jointly can exclude up to $500,00. If your profit exceeds this threshold, you may owe capital gains tax on the overage.
If you want to take advantage of the capital gains tax exclusion on home sales, you need to know the rules. Not all types of properties are eligible, and certain ownership factors can disqualify you from taking the exclusion.
Calculating capital gains tax on a home sale
The capital gains tax on the sale of a home depends on the amount of profit you make from the sale. Profit is generally defined as the difference between how much you paid for the home and how much you sold it for.
If you owned the home for a year or less before selling, short-term capital gains tax rates may apply. The rate is equal to your ordinary income tax rate, also known as your income tax bracket.
If you owned the home for longer than a year before selling, long-term capital gains tax rates may apply. These rates are much more forgiving. Many people qualify for a 0% tax rate. Everybody else pays 15% or 20%, depending on your filing status and taxable income.
Example: Let's say that you bought a home 10 years ago for $200,000 and sold it today for $800,000. Your net profit would be $600,000. If you’re married and filing jointly, $500,000 of that gain might not be subject to the capital gains tax because of the exclusion — but $100,000 of the gain could be subject to long-term capital gains tax.
Who qualifies for the home sale capital gains tax exclusion?
If you sell a house, all of the points below must be true — otherwise, you may owe capital gains taxes on the entire gain from the sale. The list is not exhaustive, as the rules for this exclusion can be complex. If you have questions, consider reviewing Publication 523 or speaking with a tax advisor.
1. The home must be your principal residence
The IRS defines "home" broadly — your home could be a condo, a co-op, a mobile home or even a houseboat. The key to being eligible for the home sale capital gains tax exclusion is that it must be your primary (what the IRS calls "principal") home, meaning the place where you spend most of your time.
Details that strengthen your home's status as primary include that the home's address is used in your official documents (tax returns, driver's license, voting registration, and with the Postal Service) and that the residence is close by to certain day-to-day needs, such as your bank, your workplace, or any types of organizations you are part of.
If you own more than one home, you should conduct a "facts and circumstances" test to make sure the home you're selling will be recognized as a principal residence by the IRS.
2. You must have owned the home for at least two years
The agency requires that you own the home for at least two years in the five-year period before you sell it. You may catch a break here if you're married and filing jointly — only one of the spouses is required to meet this test.
3. You must have lived in the house for at least two years in the five-year period before you sold it
Owning the home isn't enough to avoid capital gains on the sale — the IRS also wants to make sure that you actually intended to live in the house, at least for a certain period of time. Living in the home for at least two of the five years helps to establish this. The IRS is flexible here — the 24 months don't have to be consecutive, and temporary absences, such as vacations, also don't count as being "away."
People who are disabled or need outpatient care, as well as people in the military, Foreign Service, or intelligence community, may also be exempt from this rule. See IRS Publication 523 for details.
4. You cannot have claimed the home sale capital gains exclusion recently
You can't claim the exclusion if you have already taken it for another home in the two-year period before the sale of this home.
5. You cannot have bought the house through a like-kind exchange
Your home is not qualified for the exclusion if you purchased it through a like-kind exchange, also sometimes called a 1031 exchange, in the past five years. This kind of purchase basically means swapping one investment property for another.
6. You cannot be subject to expatriate tax
The expatriate tax is a fee levied by the IRS on certain people who have given up their citizenship or who have given up their U.S. residency status as a result of living abroad for an extended period of time. If you are subject to this tax, you can't take the exclusion.
How to avoid capital gains taxes on real estate
1. Live in the house for at least two years
The two years don’t need to be consecutive, but house flippers should beware. If you sell a house that you didn’t live in for at least two years, the gains can be taxable. Selling in less than a year is especially expensive because you could be subject to the short-term capital gains tax, which is higher than the long-term capital gains tax.
2. See whether you qualify for an exception
If you have a taxable gain on the sale of your home, you might still be able to exclude some of it if you sold the house because of work, health or “an unforeseeable event,” according to the IRS. Check IRS Publication 523 for details
3. Keep the receipts for your home improvements
The cost basis of your home typically includes what you paid to purchase it, as well as the improvements you've made over the years. When your cost basis is higher, your exposure to the capital gains tax may be lower. Remodels, expansions, new windows, landscaping, fences, new driveways, air conditioning installs — they’re all examples of things that might cut your capital gains tax.
Taxes on rental and investment properties
The capital gains tax exclusion only applies to the sale of your primary home. It doesn't work for commercial real estate, rental properties or houses used as investment vehicles. This also means your secondary home or a vacation home that you rent out in the off-season would need to be converted into your main residence — among the other rules above — for the exemption to apply.
Navigating the tax rules of selling a real estate or an investment property can be complex. Long- or short-term capital gains tax will apply upon sale, depending on how long you owned the house. But there are also ways to minimize or defer taxes on these types of properties. Consider speaking with a tax advisor or financial advisor to learn more.
Is there an over-55 home sale exemption?
No. Homeowners aged 55 and above used to be eligible for a one-time $125,000 capital gains tax exclusion on the sale of their home, but this tax law expired in 1997 and was replaced by the current $500,000 exclusion cap, which applies to a wider range of taxpayers.
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