What to Know About Capital Gains Tax When Selling a Home

What to Know About Capital Gains TaxWhen selling a home, it's important to be aware of capital gains tax. This tax is levied on the profit a homeowner makes from selling the property. However, there are ways to minimize or even avoid capital gains tax when selling a home. Read on to learn about what capital gains tax is, how it's calculated, and how to reduce it to maximize the profit from a home sale.

For informational purposes only. Always consult with an attorney, tax, or financial advisor before proceeding with any real estate transaction.

What is Capital Gains Tax?

Capital gains tax is a tax on the profits made from the sale of an asset—in the case of this article, it's real estate. The capital gain (or profit) is the difference between the sale price and the property's basis. The basis is the original cost of the property, plus any costs associated with buying or selling it.

For example, if a house was originally bought for $300,000 and sold for $700,000, the capital gain would be $400,000. That amount could potentially be subject to tax. Expenses like home improvements, repairs, and closing costs can be added to the basis to lower the profit. This, of course, would correlate with a lower capital gains tax.

How is Capital Gains Tax Calculated?

Capital gains tax falls into two rates: long-term versus short-term. Property that is held for one year or less is considered short-term capital gains, and property owned for more than a year is taxed at the long-term capital gains tax rate. The long-term rate is generally lower, so it usually pays off to hold on to a property for at least a year before selling it.

Once the capital gain is calculated, the rate is applied. For short-term capital gains, the ordinary tax rate is used. For long-term capital gains, the long-term capital gains tax rate of 0%, 15%, or 20% is used, depending on the homeowner's income and filing status. 

How to Use Capital Gains Tax Exclusions

To reduce capital gains tax, a homeowner can claim a home sale exclusion. The IRS usually allows an exclusion of up to $250,000 on a sale if the homeowner is single, or up to $500,000 if they file their taxes jointly. In order to claim an exclusion, the homeowner has to meet some criteria.

The ownership and use tests require that the homeowner has lived in the home for at least a combined two of the last five years leading up to the sale, and it has to be their primary residence. They also need to have owned the home for at least two years. The exemption can also only be used every two years, so if a homeowner recently made another sale and used the exclusion there, they're out of luck.

Using the earlier example, if the homeowner is single, they would remove $250,000 from the taxable amount. That would leave them with $150,000 to be taxed, thus saving them money. If the homeowner was filing jointly, they wouldn't owe capital gains tax at all, as the $500,000 exclusion would cover the capital gain.

How Capital Gains Tax Applies to Vacation and Rental Homes

A vacation home is not a primary residence, so it is not eligible for the home sale exclusion. This means that capital gains tax will apply to any profits from the sale of a vacation home in the same way as it would apply to any other capital gain. The long-term and short-term capital gains tax rates still apply, depending on how long the property was held.

Rental homes and other types of real estate investments may qualify for some deductions. The most common deduction is rental property depreciation, which allows landlords to deduct a portion of the rental income they earn each year. This deduction is intended to compensate for the fact that rental properties typically lose value over time. The depreciation will, however, be taxed (depreciation recapture) when the property is sold.

Don't Let Capital Gains Tax Be Confusing

When it comes time to sell your house, it's important to know the tax implications of doing so. Capital gains tax can be tricky, so understanding the basics will go a long way before making any decisions about selling a house. Thankfully, there are ways to reduce or avoid capital gains tax altogether. By learning about capital gains tax before selling a house, homeowners can make sure that they get as much money as possible from the sale.

For informational purposes only. Always consult with an attorney, tax, or financial advisor before proceeding with any real estate transaction.

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