Taxes on Selling a House
In selling a home, whether it be a family residence or an investment property, expect the Internal Revenue Service (IRS) to collect capital gains tax from the profit. Failure to declare and pay for this tax can result in fines, penalties, or worse, criminal prosecution.
Home sellers usually pay capital gains tax when their property value is appreciated significantly. But because of the Taxpayer Relief Act of 1997, many are exempted from paying it. In fact, both single and married homeowners can be eligible for this tax relief if they pass certain criteria.
If you're planning to sell a home and are afraid of its tax implications, this is the perfect read for you! Here, we'll take a look at all the nitty-gritty of capital gains taxes including their rate, how you can avoid it, partial exclusion, and more!
What Are Capital Gains Taxes?
Capital gains tax is the tax you owe on your capital gains (profit) from the sale of a capital asset or investment just as a home. You can calculate this by subtracting your cost basis or the purchase price of your home and any expenses incurred in the sale from the final sale price. Note that the final sale price may be different from your home's assessed fair market value.
Any gains you got from the sale of your home should be declared to the Internal Revenue Service when you file for your tax return in the same year. Since capital gains are tied to the value of your property, any substantial appreciation can lead to a higher capital gains tax.
Short-Term Capital Gains
Short-term capital gains result from selling a property that you owned for less than a year. It is taxed similarly to ordinary income so the tax rates depend on your marginal income tax bracket.
Long-Term Capital Gains
Long-term capital gains, as the name suggests, result from selling a property you owned for more than a year.
Long-term capital gains tax rates are almost always lower than short-term capital gains. That is why many experts advise holding onto the property for a longer period before selling.
When Is a Home Sale Fully Taxable?
Even though the majority of homeowners are eligible for a capital gains tax break under the tax code, there are still instances when a house is fully taxable. Here are some sample situations.
- The house is not the seller's primary residence.
- The homeowner sold another house within two years from the date of the home sale and has already used capital gains exclusion in that instance.
- The homeowner has to pay expatriate taxes.
- The property was bought through 1031 or like-kind exchange.
- The house isn't owned or used by the seller as a primary residence for at least two years of the last five years prior to the home sale.
How Much Is Capital Gains Tax in Real Estate?
The capital gains tax rate depends on the seller's tax filing status, income tax bracket, years of home ownership, and whether the house has been the primary/secondary residence or rental.
Typically, the rate for short-term capital gains tax is between 10% and 37% following the seven federal tax brackets for ordinary income in the United States.
This primarily differs depending on income and one's filing status, whether single, head of household, married filing jointly, or married filing separately. The highest capital gains tax is charged for married filing jointly individuals.
Note that short-term capital gains can be taxed higher than regular earnings if it causes your overall taxable income to fall into the higher marginal tax bracket.
As for the rate of long-term capital gains tax, it used to be closely similar to that of the short-term; however, the Tax Cuts and Jobs Act changed this in 2018.
Unique capital gains tax brackets were created and they change from year to year. You can expect, however, that the long-term capital gains tax rate is between 0% to 20%.
Do You Need to Pay Capital Gains Tax on Rental Property?
Yes. You need to pay capital gains taxes on a rental property. Similar to a primary residence, the sale would be taxed as an ordinary income if you owned the rental for less than a year. The capital gains tax rate is also at a 37% ceiling.
If you owned the property for quite a while, you would pay between 15% and 20% long-term capital gains taxes. This would depend on your filing status, income, and the cost basis of your home. If you claimed depreciation deduction before, this rate can increase up to 25%.
It is important to clarify that the capital gains tax on rental or investment property doesn't have the same exclusions as a family home or a main residence. In most cases, it is harder to get capital gains tax relief from a rental sale.
How to Avoid Capital Gains Taxes on Real Estate Sale?
While the amount of your capital gains tax bill can be really daunting, there's still a way around it.
The IRS is kind enough to offer some options to reduce or avoid capital gains taxes during a home sale. This differs depending on the type of property you own, your income, and your filing status.
You can be eligible for a capital gains tax break under Section 121 Exclusion if you sold a primary residence. This exemption can only be availed once every two years.
Single sellers can exempt the first $250,000 or their capital gains while married taxpayers who are filing jointly can get up to $500,000 exemption.
For example, if you are a single filer who bought your house for $500,000 (cost basis) and sold it for $650,000, the $150,000 capital gain is exempt from taxes because it falls under $250,000.
Of course, there are certain requirements for you to be eligible for this exemption:
- You should own the property for at least two years.
- You live in the property for at least two years within the five years immediately preceding the home sale.
- You haven't excluded the gain on another home sale within 2 years prior to this sale.
Note that you don't have to live on the property for two consecutive years. If you lived in the property for a year, rented it out for 2 years, and stayed in it again for another year, you can still be granted capital gains tax exemption.
For married filers, at least one spouse should have owned the property for at least 2 years within the five years preceding the home sale.
Rental or Additional Property
The capital gains tax exclusion for the sale of one investment property and any additional property is not exactly similar to a primary residence. In most cases, only a small amount can be deducted so the investor should think of a workaround.
Section 121: Primary Residence Exclusion
You may convert the rental property into a principal residence for two years before selling it. This way, you can take advantage of Section 121 or primary residence exclusion.
Note, however, that if you claimed a depreciation deduction on capital gains earned before May 6, 1997, you won't be eligible for this capital gains exclusion.
Also, if you do this now, you will lose your primary residency status on your first home. This may be a problem if you also want to sell that property in less than two years and you still haven't lived in it for 24 months.
Another tactic used by many investors to avoid huge capital gains tax during the sale of a rental property is to reinvest their profit into a similar property. This is called the 1031 exchange or the like-kind exchange. Through this arrangement, the capital gains tax can be deferred.
According to the IRS, individuals, corporations, trusts, limited liability companies (LLCs), and partnerships that own investment properties can take advantage of this deferment.
The replacement property should be identified in writing within 45 days of the rental sale and the exchange must be completed 180 days after the sale of the first investment property.
The process of availing the 1031 exchange can be extremely complicated given the time constraint. You may want to work with a 1031 exchange company to speed up the process and avoid possible missteps.
If you invest in low-income communities (Opportunity Zones) identified by The 2017 Tax Cuts and Jobs Act, you'll be able to get a step up in the original cost of the property after the first 5 years and any of your gains after 10 years will be considered tax-free.
Even if you were granted some exclusion or exemption, you may still have some capital gains tax to pay when you sold an investment property.
What you can do is lower your capital gains taxes further by reducing the amount of your taxable gain.
Here are some deductions that may qualify:
- Closing costs from the sale
- Renovation or home improvements like kitchen overhaul or adding a new room
- Cost of repairs
- Income losses due to tenants not being able to pay rent
- Cost of evicting a tenant or finding one (covers advertising, legal, and other relative professional fees)
- Certain selling costs such as title insurance, settlement fees, etc.
In order for these deductions to be considered, you should keep receipts, invoices, credit card statements, bills, and other documents that can prove your claims.
To reduce the taxable gross income from the sale of a rental or a vacation home, the seller may choose an installment sale. In this setup, a part of the gain is deferred, therefore some portion of the capital gains tax will be deferred, too.
What Is a Partial Home Sale Tax Exclusion?
If you do not qualify for the 121 primary residence exclusion or you still owe taxes after some exemptions, you can still salvage a partial home sales tax exclusion.
This can be given to you if you have a good reason for selling the home, you aren't subject to expatriate tax, and you haven't filed for exclusion in the past 2 years
Here are some of the "good reasons" the IRS considers when giving out a partial home sales exclusion:
- You moved because you need to obtain a diagnosis or treatment for yourself.
- You moved because you have to provide personal or medical care for a family member.
- Your doctor recommended you move places for your treatment. This also applies to your spouse or any family member who lives with you.
- You were transferred to an office that is 50 miles away from your home.
- You were hired 50 miles away from your home.
- Either of the cases above is true of your husband/wife or anyone who lives in the same home.
- Your home was destroyed by a natural or man-made disaster or a terrorist act.
- Your house was condemned or destroyed for any reason.
- You, your co-owner, spouse, or any resident of the house died, divorced, separated, gave birth to twins, were unemployed, etc.
Even if you did not exactly experience the situations above that led to the home sale, you can still qualify for an exception.
That is if you can prove that the main reason for the home sale falls among health, work, or unforeseeable events.
How to Report Home Sale Proceeds to the IRS
To report a property sale, you must fill out and submit Form 1099-S of the IRS. This form is used if the home sale has a non-excludable gain and is issued by the closing company, real estate agency, or mortgage lender.
If, for instance, you meet the qualifications of the IRS for exclusion, you should still inform your real estate agent by February 15 following the year of the sale.
Here's what the IRS considers non-reportable real estate transactions:
- The sales price of the property is less than $250,000 for single filers and $500,000 for married people filing jointly. The real estate agent must get attestations that the seller really meets the principal residence requirements.
- The transaction is a non-sale, but a gift
- The transaction is done to satisfy a lien
- The seller or the one who will transfer the property is a government sector, a corporation, or an exempt volume transferor
- The transaction's total consideration is $600 or less
Special Circumstances: Military Personnel and Divorce
There are special rules for divorced couples, military personnel, and government officials that can help them claim full or partial capital gains tax exclusion.
Military Personnel and Government Officials
Some government officials and military personnel who are serving an extended duty along with their spouses can extend the five-year period requirement to 15 years.
As long as the government official or military personnel lived for two years in the property in the span of 15 years, they can also get a capital gains tax break. This is $250,000 for a single filer and $500,000 for a married couple filing jointly.
This also covers members of the foreign service and the intelligence community.
To qualify for the use requirement, the spouse granted legal ownership of the property can count the years when the house was owned by the former spouse.
If a legal owner is yet to be identified and the court grants the use of a home by both parties in the separation agreement, the spouse who doesn't stay in the property can still count the days the other has lived there.
Death of a Spouse
If a spouse died and the surviving spouse did not remarry, the period the deceased lived and the property and owned it can still be considered toward ownership and use test.
Do You Pay Capital Gains if You Lose Money on a Home Sale?
The losses on the sale of a principal residence cannot be treated as a capital loss so you still have to pay tax.
If your capital losses exceed your gains, the excess loss amount that you can claim is $3,000 for single filers and $1,500 for married filers. If you own a rental, a better option would be to offset capital gains with capital losses.
Does Paying the Mortgage and Real Estate Taxes Reduce My Gain?
No. Your property taxes or real estate taxes and mortgage payoff during a sale won't reduce your gain. Remember that capital gains taxes are calculated by deducting the purchase price from the selling price.
Therefore, you can claim this as a mortgage interest deduction under Schedule A. This also applies to property taxes.
Is There an Age Limit on Who Can Avail of Capital Gains Tax Exemption in a Home Sale?
None. No matter what age you are, as long as you are a taxpayer, you can avail of a tax exemption for your capital gains on a real estate sale. The tax rate would still depend on your filing status, income tax bracket, years of home ownership, and whether the house has been the primary/sec
The misconception that there is an age limit stems from the old provision that homeowners who are at least 55 years old can only claim a one-time exclusion.
Can I Still Claim Tax Exclusion if My Home Is in a Trust?
The answer to this depends on several factors. For instance, revocable trusts that weren't disregarded and those that are considered separate entities due to federal taxes will not qualify for Section 121.
Meanwhile, revocable trusts that passed certain criteria can be disregarded. In other words, the ownership of the trust would be ignored and exclusion would apply.
How Will the IRS Know That I Sold My House if I Did Not Report it?
Even if you do not report the sale of your home to the IRS, there are real estate transactions that can trigger taxes such as lien settlement or mortgage payoff. This can be traced by the IRS and you would face legal issues.
Can You Exclude the Gain from the Sale of a Second Home?
No. You cannot exclude the gain from the sale of a second home. You would have to pay capital gains taxes since it isn't your primary residence. It will be taxed as a short-term capital gain or a long-term capital gain just like an investment property.
Final Thoughts: Taxes on Selling a House
We hope that this blog made the subject of capital gains tax less intimidating for you. Again, even if capital gains tax rates are quite high, especially for short-term capital gains tax, you can still reduce or avoid paying your tax bill under the Taxpayer Relief Act of 1997.
Now that you already know how to get ahead of home sale taxes, start looking for home buyers. Here at House Buyer Network, we'll give you an offer as fast as 48 hours and we'll also cover closing costs for you!
Give us a call at (855) 835-2544 or fill out our form below.