When Is Capital Gains Tax Required During a Home Sale?

It's a good time for home sellers, as many are making substantial profits. With these high profits, though, sellers should be aware of the possibility they'll owe capital gains tax on anything they earn. Learn below when capital gains tax applies during a home sale and how to lower the tax burden when selling a home.

For informational purposes only. Always consult with a licensed real estate professional before proceeding with any real estate transaction.

Most Home Sales Don't Involve Capital Gains Tax

Someone who sells their primary home is unlikely to owe capital gains tax. To be considered a primary home, it must pass the ownership and use tests. The homeowners must have owned the home for at least two years. They must also have lived in the home for at least two years out of the past five.

There is no requirement that the two years be consecutive. If someone bought a home, lived in it for a year, then rented it out for two years, they could pass the ownership and use tests by living in it for another year. Homeowners can only use this exclusion every two years; even if someone lives in the home, they cannot take this tax exemption if they have used it recently.

If a home is considered a primary home, up to $250,000 in capital gains can be excluded by a taxpayer who files as an individual. Married couples can exclude up to $500,000 in capital gains.

Capital gains refer to the net profit made on a home sale. So, a home purchased for $230,000 and sold for $400,000 would have $170,000 in profit from the sale.

Are Capital Gains Owed on an Investment Home? What About Rental?

If the seller buys a home, improves it, then flips it the following year for a profit, they will likely owe capital gains tax because the house is an investment rather than a primary domicile. There's also a differentiation between short-term and long-term capital gains tax, which is determined by how long the seller owned the home. Generally, the short-term tax is higher.

Capital gains tax may also apply to the sale of a home used as a rental property. However, the IRS allows a rental property to be converted to a primary residence — it needs to be occupied by the owner for at least two out of the past five years.

Ways to Lower Capital Gains Tax

Timing the sale to take advantage of the capital gains exclusion is an effective way to avoid paying capital gains tax. However, it isn't always possible to delay a sale, and doing so could mean more expenses or a lower profit, which may erase any savings realized by avoiding capital gains tax in the first place.

To make sure taxes take as small a bite as possible out of any revenue, sellers should take any relevant deductions. The costs of any improvements made to the house can be deducted from profits when it's sold. This includes any remodeling, new paint, flooring updates, and other costs related to fixing or improving the home, even aspects that may be missed during inspections.

There are also some circumstances where homeowners can avoid capital gains by buying a similar asset within 180 days of the sale. A tax attorney can help sellers navigate these rules to ensure that a purchase qualifies.

There's always a lot to manage when selling a home. Sellers can predict whether they'll have to pay taxes on the sale by researching their specific circumstances so they can be prepared. Learning a bit now can help avoid a big tax bill later.

For informational purposes only. Always consult with a licensed real estate professional before proceeding with any real estate transaction.