If you have a capital gain on a home sale, the good news is that you may qualify to exclude all or some of it from your taxable income, saving a bundle in taxes.
Laura covers what to know about selling your home and the taxes you could owe. She explains a legit way to skip taxes or pay significantly less, called section 121 or capital gains tax exclusion.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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If you own a home and are thinking about selling it or wondering what taxes you’d owe after a home sale, we’ll cover everything you need to know in today’s show. Even better, I’ll explain a legitimate way to skip taxes on a home sale so you pay much less or even nothing to the government!
Hey, friends, and welcome back to the Money Girl Podcast—I appreciate you downloading the show! I'm Laura Adams, an award-winning author who's been bringing you personal finance and small business tips every week since 2008, with more than 40 million downloads.
I also work with select brands doing on-camera and writing work as a spokesperson, consultant, and consumer advocate. So, if your company is interested in collaborating for an upcoming PR campaign or ongoing marketing, please reach out!
No matter what you want to learn about managing money, I probably have or will cover it on Money Girl. You’ll hear me talk about a wide range of topics, like building credit, dealing with debt, investing for retirement, owning real estate, paying taxes, having the right insurance, money management strategies, and lots more.
Today’s episode is number 771, which means there’s a massive archive of episodes to dig into! The shows get inspired by economic events, IRS changes, things going on in my financial life, and your questions. So please keep them coming by leaving a message at 302-364-0308 or using my contact page at LauraDAdams.com. That’s also where you can learn more about my work, award-winning personal finance books, and money courses.
First, let's define capital gains and how they relate to home selling.
You already know that you must pay ordinary income tax when you earn money from a job or business or receive interest on your bank account balance. Additionally, when you sell certain assets and have a profit, you must pay capital gains tax on your gain.
You have a capital gain when you sell a capital asset, such as stocks, mutual funds, exchange-traded funds, or real estate, for more than it cost. The capital gains tax rate depends on how long you owned the asset, your income, and tax filing status.
Note that if you sell a capital asset for a loss, you have a capital loss, which can offset similar capital gains for a period, reducing the amount of tax you owe. However, if you sell a home for less than you paid, you can't claim a capital loss or deduct it from your taxable income.
But you get a massive tax break when you profit from your home. Keep listening, and I'll explain how the gains tax exclusion works and who qualifies for it.
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So, how do you calculate your capital gain and potential tax on a home sale? As I mentioned, it’s the difference between what you paid for your property and how much you sold it for.
But calculating your gain on a home sale gets complicated because you may have made renovations or significant repairs, known as capital improvements, while you lived in the property. Plus, you typically have expenses to account for when selling your home.
Here are four basic steps to determine your capital gain on a home sale:
1. Determine your basis – which is your total investment in the property. It includes the purchase price plus expenses connected to the purchase, like closing costs.
In addition, your basis also includes the cost of capital improvements that increase your home’s value, like remodeling a kitchen, putting on a new roof, or replacing a faulty water heater. Those improvements increase your basis, which reduces your capital gain and cuts your taxes.
Note that typical maintenance and repairs—like installing new air conditioning filters, painting, and keeping up your yard—are generally not considered capital improvements and don’t affect your home’s basis.
However, certain things decrease your home’s basis, such as allowable depreciation and payments received for home insurance claims. That's why keeping good records for significant home-related expenses and insurance payments is critical.
2. Determine your realized amount – which is your home’s selling price minus any expenses connected to the sale, such as a real estate commission, marketing fees, and certain closing costs.
3. Subtract your basis from your realized amount – which is your capital gain or loss. For instance, if your home’s basis is $300,000 and your realized amount is $450,000, you have a $150,000 capital gain.
4. Determine your capital gains tax rate – which depends on your income, tax filing status, and how long you owned the property.
If you sell your home after owning it for one year or less, you must pay a short-term capital gains tax rate, which is the same as federal ordinary tax rates, ranging from 10% up to 37% for 2023. Depending on where you live, you may also owe state capital gains tax.
But capital assets owned for more than a year get taxed differently, using different rates and brackets than ordinary income. For 2023, the long-term capital gains tax rate ranges from 0% to 20%, which is more favorable than short-term rates. That’s why it’s typically best to own assets, like investments and your home, for longer than a year. Plus, you may owe capital gains tax at the state level if your state collects it.
Note that tax rates for ordinary income and capital gains can change yearly, so check TaxFoundation.org for current information.
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If you have a capital gain on a home sale, the good news is that you may qualify to exclude all or some of it from your taxable income, saving a bundle in taxes. So let’s talk about the exclusion rules, which are pretty simple.
You must have owned and lived in the home for at least two years during the five years preceding the sale, and they don’t have to be contiguous. You could have rented out your home any three of the past five years and still be eligible for the exclusion if you lived there for periods that add up to two years.
The home must be your primary residence to qualify for a gain exclusion. It can be any type of home, such as a single-family home, townhouse, condo, mobile home, tiny home, or even a houseboat. While you can own other properties, like vacation homes or rentals, they don’t qualify for this tax benefit.
And what’s really great is that you can claim the gains exclusion as often as you like. Theoretically, you could buy a home, live in it, and sell it every two years for your entire life to claim the exclusion over and over. The thought of moving that often just for the exclusion exhausts me, but it’s legal!
If you qualify, you may be eligible to exclude up to $250,000, or $500,000 if you file taxes jointly, of the gain from your primary residence. This fantastic gift in the tax code is available no matter your age or income!
I want to point out that the IRS wasn’t always so generous. The home sale capital gains exclusion used to apply only if you bought a more expensive home within two years of selling your old one. Plus, you could only claim the exclusion once in your lifetime for up to $125,0000 if you were 55 or older.
If you’re married, only one spouse must be listed as the homeowner to qualify for the $500,000 exclusion. However, both must have lived in the home for at least two of the five years before the sale.
Note that if you’re a widow or widower who doesn’t remarry before selling your home within two years after your spouse’s death, you generally qualify to exclude up to $500,000 in gains, as if your spouse were still alive.
Let’s say you’re married, file taxes jointly, bought your home for $300,000, and have lived there for 20 years. After several renovations over the decades, your adjusted basis is $500,000. You sell the property and realize $1.2 million on the sale, giving you a capital gain of $700,000 ($1.2 million - $500,000 = $700,000).
You can exclude $500,000, leaving you with a $200,000 ($700,000 - $500,000) capital gain. If you owned this same home as a single taxpayer, you’d be eligible to exclude $250,000, leaving you with a $450,000 ($700,000 - $250,000) capital gain.
There’s a worksheet in IRS Publication 523, Selling Your Home, you can use to figure out your home’s basis and any gain you can exclude. If you can exclude all your home’s gain, you don’t have to report it on your tax return because the entire transaction is tax-free! That’s a serious benefit you can take advantage of every two years if you meet the eligibility requirements.
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If you have a taxable home gain, you must report the sale or exchange of your property on Form 1040, Schedule D, Capital Gains and Losses, and Form 8949, Sales and Other Dispositions of Capital Assets. And as I mentioned, if you sell other properties that are not your main home, you must pay capital gains tax on all your profit.
However, there are legal exceptions where you qualify for the gains exclusion even if you sell your home before living in it for two of the previous five years. They include:
You may get a partial gain exclusion if you sell your home before living in it for two years due to a change in your health, workplace location, or having various unforeseeable events as described in IRS Publication 523.
That isn't a complete list of situations when you're eligible or ineligible for the home sale capital gains tax exclusion, so speak with a certified public accountant (CPA) and a Realtor or real estate agent about paying tax after selling your home. With some planning, correctly timing your sale and qualifying for the gains exclusion could be one of the biggest tax breaks you ever get.
That's all for now. I'll talk to you next week. Until then, here's to living a richer life.