Capital gains tax is a tax on the profit made when selling a capital asset like stocks, bonds, cryptocurrency, antiques, cars, and real estate. When you sell your primary residence, you may have to pay capital gains tax on any profit made over your original purchase price and improvements.
The capital gains tax rate you’ll pay depends on your income, filing status, and how long you owned and lived in the home. The IRS provides exclusions that allow many home sellers to avoid owing capital gains tax on a portion or all of their home sale profit.
How is capital gains tax calculated on home sales?
Your capital gains tax is calculated by taking the sale price of your home and subtracting the adjusted cost basis.
Sale Price
- Your home’s sale price
Minus
Adjusted Cost Basis
- Original purchase price
- Improvements and additions
- Closing costs from the purchase
Equals
Capital Gain
- The profit or capital gain from the sale
You’ll owe capital gains tax on the capital gain amount if it exceeds your capital gains tax exclusion. Your capital gains tax rate depends on your income and filing status.
Here’s an example capital gains tax calculation:
- You purchased a home for $200,000
- You added a bedroom addition costing $20,000
- You sold the home for $300,000
- Your capital gain is $300,000 – ($200,000 + $20,000) = $80,000
Based on your income, tax bracket, and filing status, you may owe 15% or 20% capital gains tax on all or a portion of the $80,000 capital gain.
What is the capital gains tax exclusion on home sales?
The IRS provides capital gains tax exclusions that allow you to avoid owing tax on a certain amount of the gain from a home sale. Here are the primary home sale exclusions:
- Up to $500,000 capital gains exclusion for married filing jointly – If you’re married and file a joint tax return, you can exclude up to $500,000 of capital gains.
- Exclusion repeats every 2 years – You can use the full exclusion amount again if you don’t sell another home for at least 2 years.
These exclusions allow many home sellers to reduce or eliminate their capital gains tax burden. However, you must meet residence and ownership requirements to qualify for the exclusions.
What are the primary residence requirements?
To qualify for the capital gains exclusion, you must meet residence and ownership tests. Here are the IRS requirements:
- Lived in home as primary residence for 2 out of last 5 years – You must have lived in the home as your primary residence for at least 24 months out of the past 60 months leading up to the sale date.
- Didn’t claim a primary residence exclusion in last 2 years – You can’t have claimed an exclusion on the sale of another primary residence in the last 2 years.
The residence requirements ensure you live in and use the home as your primary residence before taking the tax exclusion. You also can’t use the exclusions too frequently.
What are the ownership requirements?
In addition to the residence rules, you must also meet ownership requirements to qualify for the capital gains exclusion:
- Owned home for at least 24 months – You must have owned the home for at least 24 months before selling.
- Didn’t receive exclusion on same property in last 2 years – You can’t have claimed the capital gains exclusion on the sale of the same property in the last 2 years.
- Meet 5 year lookback rule – You must have owned the home for at least 24 months AND lived in it as your primary residence for 24 months out during the 5-year period ending on the sale date.
These requirements ensure you owned and occupied the property for significant periods as your primary residence rather than briefly for speculative or investment purposes.
How is capital gains tax handled for investment or second homes?
If you sell a home that doesn’t meet the primary residence requirements, you won’t qualify for the capital gains exclusion. Second homes and investment properties don’t qualify.
For these sales, your gain will be taxed at the capital gains rates based on your income and filing status. Here are the rates as of 2023:
- 0% – Single filers with taxable income less than $44,625. Married filing jointly under $89,250.
- 15% – Single filers with taxable income over $44,625. Married filing jointly over $89,250.
- 20% – Single filers with taxable income over $459,750. Married filing jointly over $517,200.
This means your capital gains tax rate on an investment property or second home sale could be up to 20% of your total capital gain.
Are there any other special considerations?
There are a few other special situations to be aware of when it comes to capital gains tax on home sales:
- Inherited homes – Inheriting a home receives a stepped-up cost basis so your capital gain is lowered. Special rules apply.
- Capital losses – If you sell your home at a loss, you may be able to deduct up to $3,000 per year against ordinary income.
- Divorce – Special rules apply for calculating capital gains in community property states after divorce.
- Converting home to rental – If you convert your home to a rental, complex recapture rules apply later when selling.
It’s important to understand how these scenarios may impact your capital gains tax liability when selling a home. Consulting a tax professional is advisable.
When is capital gains tax on home sales due?
Any capital gains tax you owe is due when you file your federal income tax return for the year in which you sold the home. You’ll report the home sale on Schedule D of IRS Form 1040.
The buyer’s settlement company will report the home sale to the IRS. So you cannot avoid or forget to report capital gains tax from a home sale.
Does home improvements increase cost basis and lower capital gains?
Yes, the cost of any eligible home improvements can increase your property’s cost basis and lower your capital gains tax liability. Here are some key facts:
- You can only include the actual costs you paid out of pocket for improvements – not the added market value.
- Itemize and save receipts for all home improvements.
- Eligible improvements include room additions, deck, fences, new roof, HVAC, and more.
- Improvements must have been made while you owned the home to count.
- Costs for repairs don’t count, only “improvements”.
- You’ll report cost basis increases for improvements on Form 8829 when filing.
Carefully tracking home improvement costs and reporting them properly can result in substantial capital gains tax savings in some cases. Consult IRS Publication 523 for eligible costs.
How can you avoid or defer capital gains tax on a home sale?
There are a few potential options to avoid or defer capital gains tax when selling a home:
- Use capital gains exclusion – Exclusions allow up to $250,000 ($500,000 married) gains tax-free.
- Delay sale at least 2 years – Waiting at least 2 years from your last exclusion use lets you utilize another.
- Perform a 1031 exchange – Exchange into another like-kind investment property to defer tax.
- Move back for 2 years before selling – Meet primary residence rules again to use exclusion.
- Sell gradually via an installment sale – Spread capital gains over multiple tax years.
- Make home energy efficient – Claim credit for eligible improvements off capital gains tax.
Proper planning and timing around utilization of benefits like the home sale exclusion can minimize or eliminate your tax burden. Consider if any strategies may help reduce your liability.
Does your state have capital gains tax on home sales?
In addition to federal capital gains tax, you may also owe state capital gains tax when selling a home at a profit. Here are some key facts about state capital gains taxes:
- Only 13 states + Washington DC levy capital gains tax.
- California, Hawaii, Minnesota, New Jersey, Oregon, Vermont, and DC have the highest state capital gains tax rates.
- Most states follow federal capital gains brackets based on your income.
- Some states like Florida, Texas, Nevada, and others have no state income tax.
- You can take the federal home sale exclusion before calculating state capital gains.
- Check your specific state’s capital gains tax rules and rates if you owe federal gains tax.
So you may end up with a double capital gains tax hit – both federal and state taxes on your home sale profit. Understanding both is key to proper planning and minimizing taxes owed.
how much time after selling a house do you have to buy a house to avoid the tax penalty?
You have 2 years after selling your home to buy a new primary residence and avoid the capital gains tax penalty. Here are some key points on the timing:
- If you sell your primary residence, you qualify for the capital gains tax exclusion as long as you lived there 2 out of the past 5 years. This allows you to exclude up to $250k ($500k married) in gains.
- However, if you don’t buy a new primary residence within 2 years, then the IRS can recapture some of the capital gains tax excluded if the new home is cheaper.
- For example, if you exclude $200k in gains but then buy a new house for $100k less than you sold the old house for, you may owe capital gains tax on up to $100k.
- So you have a 2 year window after selling to buy a new primary residence of equal or greater value and avoid capital gains tax penalties.
- If you wait longer than 2 years, the exclusion expires and you lose the benefit if the new home’s value doesn’t exceed the sale price of the old home.
So in summary, you have 2 years after the sale of your primary residence to buy a new primary residence and avoid any capital gains tax recapture penalties. Consulting a tax professional can help ensure you comply with the rules.
What is the capital gains tax rate in each state?
Here are the current capital gains tax rates levied by states that tax capital gains from a home sale:
California
- 0% on income up to $61,214 (single), $122,428 (married joint)
- 9.3% over $61,214 (single)
- 11.3% over $1 million
Connecticut
- 3% on income over $50,000 (single)
- 5% on income over $100,000 (single)
- 7.5% on income over $200,000 (single)
- 6.9% on income over $500,000 (single)
Hawaii
- 5% on income $2,400 to $144,400 (single)
- 6.4% on income $144,400 to $263,500 (single)
- 6.8% over $263,500 (single)
Idaho
- 7.4% on all net capital gains
Minnesota
- 5.35% on income over $29,610 (single)
- 7.05% on income over $171,810 (single)
- 9.85% on income over $276,200 (single)
New Jersey
- 1% on income up to $250,000 (single)
- 2% on income $250,000 to $500,000 (single)
- 3.5% on income $500,000 to $5 million
- 10.75% on income over $5 million
Oregon
- 8% on income over $125,000 (joint)
- 9% on income over $250,000 (joint)
Rhode Island
- 3.75% on all income
- 4.75% on income over $147,150 (single)
Vermont
- 3.35% on income $216,300 to $625,500 (joint)
- 7.8% on income $625,500 to $1.5 million (joint)
- 8.75% on income over $1.5 million (joint)
Washington DC
- 8.95% on income over $40,000 (single)
Wisconsin
- 7.65% on income over $280,950 (joint)
What are some best practices for minimizing capital gains tax?
If you will likely owe capital gains tax on a home sale, here are some tips to help minimize the amount due:
- Time the sale to maximize exclusions – Wait at least 2 years between sales to reuse the $250K or $500K exclusion.
- Invest in home improvements – Documented improvements reduce capital gains.
- Hold onto the property longer – Gains tax applies only to appreciation after you purchased.
- Donate the property – You can avoid tax on the appreciation and get a deduction.
- Move back meeting primary residence rules – Relocating resets the clock for exclusions.
- Purchase a new home using a 1031 exchange – Defer your gains reinvesting in another property.
- Claim green energy efficient home credits – Make upgrades for a tax credit before selling.
- Review with a tax pro – A CPA can review your situation and suggest custom strategies.
With proper planning and timing, many home sellers are able to reduce or eliminate capital gains tax owed. But work with a tax professional to understand the optimal moves for your situation.
Frequently Asked Questions About Capital Gains Tax on Home Sales
How is capital gains tax on primary home sales calculated?
Capital gains tax on a primary home sale is calculated by subtracting your adjusted cost basis from the sale price. Your adjusted basis includes the original purchase price plus improvements made over the years. Any gain over your exclusions ($250K single or $500K married filing jointly) may be taxed.
What home improvements add to basis and lower capital gains tax?
Eligible home improvements that add to your cost basis include room additions, remodels, plumbing, electrical, HVAC, new roof, paving driveway, kitchen upgrades, finished basement, outdoor additions like decks, fences, and more. Keep all receipts.
Can you avoid capital gains tax when you sell an inherited home?
Inherited homes receive a stepped-up cost basis to the market value at the date of death. So the capital gain is reduced, lowering any potential capital gains tax. Special rules apply to inherited properties.
What are capital gains tax rates on home sales?
Capital gains tax rates on home sales range from 0% to 20% based on your taxable income and filing status. Gains are taxed at 0% for lower incomes, 15% for middle incomes, and 20% at the highest taxable income levels. State capital gains taxes may also apply.
How can you defer or spread out capital gains tax on a home sale?
You may be able to defer capital gains tax by reinvesting in another like-kind property via a 1031 exchange. You can also spread gains over multiple years using an installment sale. Closing costs and home sale exclusions also help defer taxes owed.
Can you avoid capital gains tax on sale of home inherited from parents?
Inherited homes receive a stepped-up cost basis to the market value when the owner died. So selling an inherited parental home generally allows you to avoid capital gains tax. Special rules apply to inherited properties, however.
Does converting home to rental reset 2 out of 5 years for capital gains exclusion?
Yes, converting your primary residence into a rental property resets the 2 out of last 5 years occupancy test. To qualify for the $250K or $500K capital gains exclusion again in the future, you’ll have to move back meeting the 2 year residece rules.
Can you avoid capital gains tax when you sell home to a relative?
Selling your home to a relative does not exempt you from owing capital gains tax if you have taxable gains over the exclusion amount. There is no special treatment when selling to family. You still must report the sale and pay applicable taxes.
How does capital gains tax on home sale work if you divorce?
Divorcing spouses in community property states must split the cost basis and capital gains down the middle to calculate tax each owes. Special rules determine how to divide and report the gain to account for the time before and duration of the marriage.
Conclusion
Calculating and minimizing capital gains tax from the sale of your home can get complicated quickly. Rules regarding primary residence exclusions, ownership periods, improvements, and other issues take careful planning and timing to optimize.
Fortunately, the generous IRS exclusions allow many home sellers to completely avoid owing any capital gains tax on profits up to $250,000 for single filers or $500,000 for married joint filers. Properly reporting eligible home improvements and costs can further reduce your taxable gains.
But for investment properties or second homes, capital gains tax could take a sizable cut out of your profits. Connecting with a knowledgeable tax professional is key to navigating the complexities and utilizing techniques to limit your liability. With the right moves at the right times, you may be able to minimize or defer the capital gains tax bite.
