So you sold your home and just left the closing attorney’s office with a fat check. Not just a big check—but the biggest check you’ve ever held in your sweaty palm.
After the excitement fades and you recover from your celebratory steak dinner, you might be wondering: Do you have to pay taxes on a home sale? The answer is maybe.
The IRS calls profits from the sale of a home or another investment capital gains. And capital gains are taxed at different rates depending on whether the investment you made was short-term (less than one year) or long-term (over one year). The rates also vary depending on your income.
But, hey, don’t lose hope just yet. The great news about selling a home is that the profit is often exempt from capital gains taxes. That’s right! Tax-free, baby. But just like anything tax-related, there are some hoops to jump through.
How Much Is Capital Gains Tax on the Sale of a Home?
Okay, so here’s the deal. If the home you sold was your primary residence for at least two of the last five years, you don’t have to pay capital gains taxes on your profit up to a certain amount. And the IRS is pretty generous (for once!) on how much profit they exclude from taxes.
Taxes shouldn’t be this complicated. Connect with a RamseyTrusted tax advisor.
If you’re single, any profit up to $250,000 is excluded from taxes. For married filing jointly, the amount doubles to $500,000.1 And profit doesn’t simply mean how much money you got when you sold your house. And that’s a relief since that check you get at closing could be much bigger than what’s considered profit—especially if you’ve been working hard to pay off your house.
Profit is the sales price minus the original purchase price and the cost of improvements, fees and commissions. Now if the housing market in your area has gone bonkers, and you cleaned up on the sale of your house, you only pay taxes on the amount above the $250,000 or $500,000 threshold.
Let’s look at an example. Say you and your spouse bought a house 10 years ago for $300,000 in an up-and-coming part of town. You followed our recommendations and put 20% down ($60,000) and got a 15-year fixed-rate mortgage. After 10 years of payments, you owed just $93,000 when you decided to sell. The home values in your area have shot up like crazy, so you were able to sell your home for $900,000! Boom! You couldn’t stop smiling for a week.
So to figure out your profit, you take $900,000 and subtract the original $300,000 sales price, about $55,000 in commissions and fees and let’s say $20,000 in home repairs (a roof and new furnace). That equals $525,000 profit. Since the tax-free threshold for married couples is $500,000, you’ll pay capital gains taxes on just $25,000.
What Is the Capital Gains Tax Rate on a Primary Residence?
So, $525,000 is a big pile of money, but since you only owed $93,000 on your home, you actually walked away with $752,000. Here’s the math: $900,000 (sales price) - $55,000 (commissions and fees) - $93,000 (mortgage payoff) = $752,000.
Now to your tax bill. Short-term (less than one year) capital gains are taxed at your regular income tax rate. Long-term (more than one year) capital gains are taxed based on your income. If your taxable income is less than $40,400 for single filers or $80,800 for married filing jointly, your long-term capital gains tax rate is 0%!2
The long-term capital gains rate is 15% for single filers with taxable incomes between $40,401 and $445,850 and for couples filing jointly with incomes between $80,801 and $501,600.3 Above those incomes, the rate is 20%.4
Notice these rates are much lower than normal federal income tax brackets.
The median household income in the United States in 2020 was $67,521.5 So that means a good number of people, depending on whether they’re single or married, fall into the 15% bucket (or are right on the border).
Let’s go back to our example where your taxable profit was $25,000. Assuming your household income puts you in the 15% capital gains bracket, you’ll owe $3,750 in taxes. Yes, that’s a lot of money, but when you consider you got $752,000 from the sale of your home, it’s small potatoes.
How to Avoid or Reduce Capital Gains Tax on Home Sales
If you met the two-year residency requirement, meaning your home was your primary residence for at least two of the last five years (and you have the random carpet stains to prove it), you probably won’t get hit by capital gains taxes when you sell your home because the profit threshold ($250,000 to $500,000) is so high.
But if you earned a profit on a home you lived in for less than two years, the Tax Man is going to come calling. And he could hit you with a big bill! Whether you fix up and flip houses or just decided to move to a new neighborhood, if you don’t meet the residency requirement, you’ll be taxed on your profit at either your regular income tax rate (if you owned the house for less than a year) or the capital gains rate (if you owned the house over a year).
There are a few ways to avoid the capital gains tax, but the big one is to stay put! Don’t sell your house before you’ve owned it for two years.
Capital Gains Tax Residency Exclusions
The IRS has several exclusions to the residency requirement.
- If you’re a member of the Armed Forces and get called up to active duty, you qualify for an exclusion.
- Other “unforeseeable” circumstances also qualify for an exclusion, like if the home was destroyed, condemned or suffered a loss due to a natural or man-made disaster.6
- You also qualify if a primary resident of your home died, got divorced or legally separated, gave birth to twins or other multiples, lost their job, or could no longer afford the home due to a change in employment.7
The IRS also has partial exclusions if you sold your home due to a job relocation, a health issue that required you to be closer to medical facilities for a family member, or to provide personal care for a family member with an illness.8 A partial exclusion is calculated based on how long you lived in the home.
So, if you’re single and lived in your home for one year (half of the two-year residency requirement), you qualify for 50% of the $250,000 exclusion. That’s $125,000. As you get closer to the two-year requirement, the amount you can exclude increases.
If you don’t qualify for an exclusion, your best bet for lowering your tax bill (at least a little) is to create a detailed list of all the improvements you made to your home so you can subtract them from your profit. Bought a new hot water heater? Replaced the windows? You can subtract those costs from your profit.
The real estate market is crazy right now, and house prices in many cities increased by double digit percentages last year. So that means you could get hit by a big tax bill if you decide to sell your home before you meet the two-year requirement. But in a normal market, if you sell a house after owning it for less than two years, most (if any) of your profit will be eaten up by real estate agent fees (typically 6% of the sales price) and closing costs. The longer you stay put in your home, the more equity you earn (equity is how much your home is worth, minus how much debt you owe on it).
How Much Is the Capital Gains Tax on a Rental Property?
If you own a rental property, the rent you collect is considered regular income, and you’ll pay taxes on it like a normal paycheck. But if you decide to sell the property, you’ll owe capital gains taxes on your profit. And since a rental is not your primary residence, you won’t be able to exclude a portion of your profit.
So if you owned the property for less than a year, you’ll pay short-term capital gains taxes at your normal income tax rate. If you owned the property over a year, you’ll pay long-term capital gains taxes at a rate of 0%, 15% or 20% depending on your income. (We talked about those income ranges earlier.)
How to Avoid Capital Gains Tax on a Rental Property
Just like selling a primary residence, you can subtract the cost of improvements, real estate commissions and closing costs from the gain you earned on your rental property. That’ll lower your tax burden some, but the really cool way to avoid capital gains taxes is doing a 1031 exchange. Ugh, the IRS and their numbered forms. But hang with us. This’ll be worth it.
A 1031 like-kind exchange allows you to defer paying capital gains taxes if you reinvest the proceeds from the sale of a property into another similar property. That’s right: If you sell a rental home and buy another with the money you made on that sale, you won’t have to pay capital gains taxes on the sale. The IRS allows you to do as many 1031 exchanges as you want, but as soon as you stop investing your proceeds into similar properties, you’ll have to pay capital gains taxes.
The IRS is somewhat flexible on the term “similar.” For instance, you could sell a rental home and buy a commercial property or an apartment complex and defer capital gains taxes. But you couldn’t sell a home and invest the money in mutual funds or some other investment like cryptocurrency (crypto is never a good idea anyway). Well, you could. You’ll just have to pay taxes on it.
The IRS has a couple of rules for 1031 exchanges though. First, you must identify the new property you want to buy within 45 days.9 (That means you’ll need to shop for another property ASAP.) Second, you must close the sale within 180 days.10 Whoa, that’s a lot of pressure—especially if you’re the type who takes three hours to make a simple decision like which movie to watch. So the key is to plan ahead!
A 1031 exchange is kind of like a game of musical chairs. The music starts when you sell your property. You’re feeling good and have cash in hand as you investigate some potential properties to buy. But then the music starts to slow, and you get nervous and wonder if you’ll be able to find a place. Other people are eyeing the properties you want. And then . . . silence. The music stops. You’re left holding your money and have no place to park it. Your heart sinks. And then you hear a knock at the door. It’s the Tax Man.
But if you find yourself in that situation, don’t lose hope. Paying taxes isn’t the end of the world. It’s far better to pay capital gains taxes than to make a hasty decision and buy a not-so-great property just because you ran out of time to do a 1031 exchange. If you buy a property just to avoid taxes, you might end up paying the stupid tax (a mistake with lots of zeroes on the end). The stupid tax doesn’t have tax brackets. It could be a lot more than the 15% capital gains rate.
We said it before, but it’s worth repeating: Plan ahead when selling a rental property.
Work With a Pro
Hey, selling a home or investment property can be complicated, but it doesn’t have to be. Finding a top-performing agent who knows your market is a must! We can connect you with the best agents in your area through our Endorsed Local Providers (ELP) program.
ELPs are experienced agents who will serve you with excellence. They’ve worked hard to be the best in the business—and they’ve earned the right to be called RamseyTrusted. That means we’ve vetted them, and we trust them to put your needs first. Period.
And if you do end up in a situation where you’re going to owe capital gains taxes, a RamseyTrusted Tax ELP can help you make sure you’re doing your taxes right the first time.