Selling your home is exciting, especially if you make a profit on the sale. Unfortunately for some homeowners, that thrill might be short-lived. The process of turning over a property can be long and arduous, from finding a buyer, shouldering the closing costs, and even dealing with the property tax. If you don’t qualify for an exception, you might be handed a hefty tax bill for the money you gained on the house.
This tax is called a capital gains tax. Capital gains are the profit you earn when you sell some form of a capital asset, like real estate.1 This money is included in your taxable income for the year, although the tax rate on the capital gain is usually lower than that for the rest of your income. But what if the home is passed down from your mother or father? In this case, do you pay capital gains for inherited property? Yes, but only if you sell it.
The good news is that there are ways to avoid paying extra taxes, whether you’re selling a primary residence or an investment property. In our guide, we’ll discuss the various ways a seller can avoid capital gains tax on a home sale.
Primary Residence: Capital Gains Tax
When selling your primary residence, rather than an investment property, you have more opportunities to exempt capital gains tax payments—many homeowners qualify for a capital gains tax exemption when they sell their home
, unless they make a significant profit.
As such, let’s take a look at how that exemption works in terms of home sales and what you’ll need to qualify.
How To Avoid Capital Gains Tax for a Primary Residence
To avoid capital gains on a home sale and qualify for a tax exemption, you must be able to demonstrate that you’ve:2
- Owned the property for at least two years
- Lived in the home for at least two out of the last five years
- Avoided using the capital gains exemption in the last two years
If you meet these qualifications, you’re eligible for an exemption to paying the capital gains tax, which is determined by your marital status:
- Single people – Individuals are allowed to exempt up to $250,000 in earned income from a home sale.
- Married couples – Those who are married and file taxes jointly are able to receive a tax exemption for the first $500,000 of profit from the sale of a property.
The amount of earned income is calculated by taking the cost basis of the property and subtracting that from the final sales price.
How Capital Gains Tax is Determined
If you’re wondering how the tax exemption on a home sale is calculated, you’re not alone. Essentially, a tax exemption is based on the amount of profit you earned from the sale. The profit is determined by two factors:
- Cost basis – The cost basis is the amount you initially paid for an asset. It includes the taxes and any other expenses you paid at the time you bought the asset.
- Adjusted cost basis – Homes can either increase in value with improvements or depreciate if not kept up. The amount of value-added or subtracted gives you the adjusted cost basis.
For example, let’s say you added $40,000 in value to your home with a kitchen upgrade, and you originally paid $190,000 for your home last year. Then a job change causes you to put your house on the market, and you sell your home for $260,000.
Instead of paying capital gains tax on $70,000, you’d only pay it on $30,000 since you spent $40,000 to improve your home, which made the adjusted cost basis $230,000. If you think about it, $40,000 is a significant tax break. So take note of any improvements or damages as they can affect the adjusted basis of the capital gains tax on a home sale.
How is Capital Gains Tax Calculated?
Once you’ve taken all the other factors we’ve discussed into account, the simple formula for capital gains tax calculation is:3
- Step 1: Determine your cost basis (A)
- Step 2: Calculate the sales price, excluding any fees and commissions you paid (B)
- Step 3: Subtract B from A to determine your capital gains
The capital gains amount is what you’ll pay taxes on.
Investment Properties: Capital Gains Tax
Investment properties and capital gains taxes are a little trickier. But, there are some methods you can use to avoid capital gains taxes on the sale of an investment property.
Generally, investment properties can incur two types of capital gains taxes—short-term capital gains and long-term capital gains taxes.
Short-Term Capital Gains Tax
A short-term capital gains tax would apply if you’ve owned your investment property for less than one year. The short-term capital gains rate is much higher than the long-term capital gains rate.4 As such, you can expect to pay between 10% to 37% in income tax, depending on the tax bracket that you fall into.
Long-Term Capital Gains Tax
Property that you’ve owned for over a year is subject to a long-term capital gains tax. Unlike the short-term tax, you’ll actually pay less than your normal income tax rate on long-term gains. The tax percentage is determined by your income level:
- 0% tax – Single people making up to $40,000 or married people filing jointly making up to $80,000 have a capital gains tax exclusion on a long-term investment. If you file as the head of household, your income can be up to $53,600 before you’d pay.
- 15% tax – For single people, the 15% tax applies if you make between $40,001 to $441,450. Married couples who make $80,001 to $496,600 and heads of households who make $53,601 to $469,050 would also pay 15%.
- 20% tax – Single people making over $441,450, couples making $496,601 or more, and heads of households making more than $469,050 are subject to a 20% tax.
How to Avoid Capital Gains Tax on an Investment Home
Luckily, there are ways to avoid a capital gains tax on investment properties, regardless of income bracket.
Option 1: Offset the Gains
Also known as tax harvesting, offsetting the gains with losses can balance your income so that you avoid paying capital gains taxes on the sale of a rental property.5 This typically only works if you’re an investor who has more than one property to sell.
For example, you sell one of your investment properties and, once the cost basis is calculated, you determine that instead of gaining money, you’ve actually had a loss of $50,000. You sell a second property in the same tax year and your capital gain is $50,000. As such, the capital loss would offset the gain and you wouldn’t be subject to the capital gains tax.
Option 2: 1031 Exchange
Another method of avoiding the capital gains tax is called a 1031 exchange.6 Wondering, what is a 1031 exchange property? It is a property that is traded with another that is similar in value through the 1031 exchange. This process allows you to sell one property and invest the money in another similar property. So then, what happens when you sell a 1031 exchange property? You have up to 180 days from the sale of the first property to then find a replacement property.
An important thing to note with a 1031 exchange is that the taxes are deferred, not eliminated entirely. Some investors take advantage of this by continually buying and selling property.
However, this process sounds much easier than it is since you must meet certain requirements pertaining to the style and quality of the properties you’re buying and selling.
Option 3: Buy Property with Your Retirement Account
If you have a tax-deferred retirement account, you might be able to use this money to purchase property and let any gains from that property accumulate without paying the taxes. Accounts that are tax-deferred include:
- Roth IRA
You aren’t subject to paying the capital gains tax unless you withdraw money from the account. Like a 1031 exchange, this is a method of deferment rather than a full exemption. However, it can be a useful method of buying and selling properties to build your retirement account and then pay taxes slowly over time rather than all at once.
Option 4: Convert it to a Primary Residence
Some homeowners convert their rental property to a primary residence to avoid the capital gains tax. All of the stipulations of the primary residence exemption would then apply, including the:
- 2-year residency rule
- Income restrictions
- Regulation against using the exemption within two years of last use
If you can meet these requirements, you’d have a higher ceiling before being subject to the capital gains tax. Individuals can make up to $250,000 and married couples up to $500,000 before they begin to pay tax on their capital gains.
Converting a rental property to a primary residence is not as easy as it sounds, especially when the rental property was acquired through a 1031 exchange. Congress made several changes to the IRS section 121 that requires a longer qualifying period for former rental properties before they can be converted into principal residence. With these changes in place, there is still a chance that the IRS would collect capital gains tax even after the conversion.88
Option 5: Sell at the Right Time
This strategy can work for both primary places of residence and investment properties. For example, some years, you might earn more than others. Controlling the date on which you sell your home by considering your yearly income can allow you to manage how much you’ll have to pay in taxes and may help mitigate your tax liability.
The IRS won’t tax capital gains if your taxable income is less than $80,000. Therefore, if you are able to sell a home during a year where you have less taxable income, you can avoid the additional tax bill.
Sell Your Home Easily with FlipSplit
The process of selling a home can be complex and the capital gains tax can make it even more so. While there are ways to avoid paying extra taxes when you sell your property, including exemptions and strategic investments, not everyone is in a position to do so.
If you want to eliminate some of the anxiety over selling your home, FlipSplit can help. With FlipSplit, homeowners and sellers can consult with a tax expert at any time to determine they are planning accordingly.
We buy houses in any condition for cash, from Los Angeles to San Diego. Then, we make value-enhancing improvements, sell the house, and split the profit with you. Contact us today to get an offer on your home.
- Tax Policy Center. How Are Capital Gains Taxed. https://www.taxpolicycenter.org/briefing-book/how-are-capital-gains-taxed
- IRS. Sale of Residence – Real Estate Tax Tips. https://www.irs.gov/businesses/small-businesses-self-employed/sale-of-residence-real-estate-tax-tips
- H&R Block. How to Figure Long Term Capital Gains Tax. https://www.hrblock.com/tax-center/income/investments/how-to-figure-capital-gains-tax/
- Forbes. What is the Capital Gains Tax Rate? https://www.forbes.com/advisor/investing/capital-gains-tax/
- Forbes. Can Tax Loss Harvesting Improve Your Investing Returns? https://www.forbes.com/advisor/investing/tax-loss-harvesting/#:~:text=Tax%20loss%20harvesting%20is%20when,thereby%20reducing%20your%20tax%20bill
- IRS. Like-Kind Exchanges – Real Estate Tax Tips. https://www.irs.gov/businesses/small-businesses-self-employed/like-kind-exchanges-real-estate-tax-tips
- IRS. Topic No. 409 Capital Gains and Losses. https://www.irs.gov/taxtopics/tc409
Kitces. Limits To Converting Rental Property Into A Primary Residence To Plan For IRC Section 121 Capital Gains Exclusion.