Laura answers a question about selling your home and explains a legit way to skip taxes or pay significantly less, called the capital gains tax exclusion.
Laura answers a question about selling your home and explains a legit way to skip taxes or pay significantly less, called the capital gains tax exclusion.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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Al M. asks, "I plan to sell my primary residence for $1.5 million with a profit of $1 million, which will get reduced to $750,000 after claiming the $250,000 capital gains exemption. If I buy a much smaller house for $600,000, am I still taxed on the $750,000 profit?
Thanks for the question, Al! I'll answer it today: the show's first Friday Q&A episode!
Welcome back, everyone, and thanks for joining me. I'm Laura Adams, an author, media spokesperson, money speaker, founder of The Money Stack newsletter, and host of the Money Girl podcast with 43 million downloads.
If you're not already subscribed to the podcast, that's the best way to ensure you never miss an episode. If you have a question you'd like me to cover, please leave it on our voicemail line at 302-364-0308. You can also send an email using my contact page at LauraDAdams.com.
What are capital gains and losses?
First, let's review capital gains and how they relate to home selling. You probably know that you pay ordinary income tax when you earn money from a job or interest on a bank account. Additionally, when you sell certain assets and have a profit, you must pay capital gains tax.
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 costs. The capital gains tax rate depends on your income, tax filing status, and the time you owned the asset.
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 sale. So, if you're like Al and thinking about selling your home, it's critical to understand how it works and who qualifies for it.
RELATED: How to decide if you should rent or buy a home
What is the capital gains tax exclusion?
The tax break for homeowners is called the capital gains tax exclusion. It's a federal benefit that allows you to exclude up to $250,000 of home sale gain from your income as a single taxpayer or $500,000 if you're married and file a joint tax return.
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.
Who qualifies for the capital gains tax exclusion?
However, to qualify for the exclusion, 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. That rule is a primary reason I recommend waiting to buy a home until you're confident you'll live there for at least two years.
The home must be your primary residence to qualify for the capital gain tax exclusion. It can be any type of home, such as a single-family home, townhouse, condo, mobile home, tiny home, or 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, no matter your age or income. In theory, 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. While the thought of moving that often just for the exclusion exhausts me, it's legal!
I want to mention that the IRS wasn't always so generous. The gains exclusion used to apply only when 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.
Al, I'm wondering if that old rule is why you asked if the price of your new home matters. Unfortunately, you will be taxed on your home sale profit, less the $250,000 exclusion if you're single. I’ll explain how to figure out your tax in a moment.
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.
There are legal exceptions where you qualify for the full or partial gains exclusion even if you sell your home before living in it for two of the previous five years. They include:
You may also 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, Selling Your Home.
I haven’t mentioned all the situations when you're eligible or ineligible for the exclusion, so speak with a certified public accountant (CPA) if you need guidance. With some planning, correctly timing your sale and qualifying for the gains exclusion could be one of the biggest tax breaks you ever get!
What is the capital gains tax on real estate?
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 somewhat complicated because you may have made renovations or significant repairs, known as capital improvements while living 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. Calculate your basis.
Your basis in a home is your total investment in the property. It includes the purchase price plus expenses related to the purchase, like closing costs. Your basis also includes capital improvements that increase your home's value, like remodeling a kitchen, installing a new roof, or replacing windows. But it doesn't include typical repairs and maintenance.
Your home's basis can also be decreased by 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.
Your home's selling price minus expenses related to the sale, such as a real estate commission, marketing fees, and certain closing costs, is your realized sale amount.
3. Subtract your basis from your realized amount.
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.
Your capital gains tax rate depends on your income, tax filing status, and how long you owned the property. For 2024, if you have owned your home for over a year, the long-term capital gains tax rate applies, which ranges from 0% to 20% and is more favorable than short-term rates.
That's why it's typically best to own assets, like investments and your home, for at least a year. Plus, you may owe capital gains tax at the state level if your state collects it. As mentioned, owning your home for at least two years makes you eligible for the capital gains tax exclusion.
You can check TaxFoundation.org for current capital gains tax rates. You can also refer to IRS Publication 523, Selling Your Home, which has a worksheet to determine your home's basis and any gain you can exclude.
If you can exclude all your home's gain, you don't even have to report it on your tax return because the entire transaction is tax-free!
What if you must pay capital gains on a home sale?
If you’re like Al and can’t exclude all the gain from your home sale, you must report the taxable portion on Form 1040, Schedule D, Capital Gains and Losses, and Form 8949, Sales and Other Dispositions of Capital Assets. As I mentioned, if you sell properties that are not your main home for a profit, you must pay capital gains tax on all of it.
Al, good luck with your home sale, and thanks again for sending in your question!
That's all for now. I'll talk to you next week on our Wednesday show. Until then, here's to living a richer life!
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