How To Avoid Capital Gains Tax When Selling Your Home

Few feelings are better than selling the house you’ve owned for a long time – for hundreds of thousands of dollars more than you paid for it.

With the way that real estate prices soared during the pandemic, some people who live in superheated markets like Southern California or Long Island might even make more than a million dollars on the sale of their home.

For most home sellers, that’s “found money.”

At least, until it’s time to file their taxes. That’s when they may discover that the government wants a share of the profit.

Not everyone finds themselves in this unfortunate situation. Many home sales are exempt from taxes, and there are ways for some homeowners to minimize their tax bill.

But others end up stuck paying the dreaded capital gains tax on the profit of their home sale – and that can cost them big money.

What is the capital gains tax? How does it apply to houses? And how can you avoid paying it when you sell your home?

The answers are a bit complicated, but let’s try to simplify them.

How Does the Capital Gains Tax Work?

Virtually no lower-income Americans, and only about ten percent of middle-income Americans who make less than $250,000, pay capital gains taxes. On the other hand, about half of those earning high incomes are subject to this somewhat-controversial tax that’s often the subject of political debate.

In a nutshell, you receive what’s called a “capital gain” when you sell something for more than you paid to buy it. For tax purposes, the original price (and the costs of acquiring it) is known as the item’s “basis.” The capital gains tax is figured on the difference between the basis and the selling price.

Capital gains are commonly calculated (and taxed) in the investment world, since the whole purpose of buying stocks (or any other type of investment) is to make money. But even if you sell a car or computer gaming system for a higher price than you bought it for, that’s literally a capital gain.

No one at the IRS will know or care if you make a few extra bucks selling a car. But you have to report gains (and losses) on “real” investments like stocks.

As with just about any tax, there are lots of ins-and-outs to be aware of. For starters, if you sell something within a year of buying it you’ll pay regular income tax on the profit, not a capital gains tax. After a year, your “capital gain” is usually taxed at a lower rate than standard income would be. There’s a reason for that: the tax is designed to encourage people to invest for the long-term, not for quick profits.

Another twist to be aware of is that this tax is due on the total amount of capital gains realized each year, not on each individual transaction. That matters because you’re allowed to deduct a small amount of capital losses incurred in the same year. You can only reduce your capital gains by a maximum of $3,000 per year. Any additional losses can be carried over, though, so another $3,000 can be deducted the following year and so on.

There are other rules involving capital gains, but they’re not worth getting into here.

Capital gains tax rates change periodically. As of this writing, the first $40,400 of capital gains ($80,800 for married couples filing jointly) isn’t taxed at all. Amounts up to about $450,000 to $500,000 (depending on filing status), are taxed at 10%. After that, the capital gains tax rate is 20%.

Why is all of this important? We’ve already touched on the answer: the profit you make when selling your home may be subject to the capital gains tax.

Bottom Line: The profit you make on investments that you’ve held for more than a year is viewed as a “capital gain” rather than ordinary income, and it’s subject to a special capital gains tax instead of income tax. In most cases, the capital gains tax rate of 10% or 20% will be lower than the income tax rate you pay. And the profit on a home sale falls into the category of a capital gain, meaning you may have to pay a capital gains tax on that profit.

The Rules on Home Sales and Capital Gains

Don’t panic just yet. There’s a very good chance you won’t have to pay any capital gains tax when you sell your house.

We’ve already mentioned one reason: annual capital gains of $40,400-$80,000 (depending on tax filing status) aren’t taxed at all. If you made less than that when selling your home, and don’t have other capital gains (like from stocks) to declare, you’re obviously home free (no pun intended).

And there’s even better news. As long as the house is your principal residence, and you’ve lived there for at least two of the five years before you sold it, you can exclude up to $250,000 of your profit from capital gains taxes. If you’re married and file taxes jointly, you can exclude up to $500,000 of the capital gain. (And if you move often, you can claim this exemption once every two years.)

So generally speaking, if you bought your house for $200,000 twenty years ago, and sold it for $600,000 – you’re off the hook and don’t have to pay capital gains taxes on the investment.

Why “generally speaking?” Because, as with all tax laws, there’s a bunch of fine print to be aware of.

The Nitty-Gritty of Figuring Capital Gains on a House

Some of the fine print in the capital gains law actually benefits the home seller. Let’s use the example we just described, but increase the final selling price to $700,000.

If someone asks you how much you made on your house, you’d probably take the amount you just sold it for ($700,000), deduct what you originally paid for it ($200,000), and say you made a $500,000 profit. That would cross the capital gains tax threshold.

But the government lets you deduct a whole lot more than the home’s original price. You can also deduct the closing costs (including escrow fees and prepaid property taxes) and the selling costs (like realtor commissions and home staging) that you just paid.

Let’s say that you paid a total of $60,000 in selling and closing costs. You’d get to deduct $200,000 from $640,000, making your profit – in the government’s eyes – $440,000, not $500,000.

We’re not done yet, either. Remember that a capital gain is defined as the difference between the sales price (after subtracting any allowed deductions) and its “basis” price. In many cases, like stocks, the basis is simply what the item was purchased for. When it comes to houses, there are other factors to consider.

Let’s start with the $200,000 you paid for the home. Now let’s say that when you bought it you paid $10,000 in closing prices, and while you owned it you added $40,000 worth of improvements. Those get added to the basis price. So the home’s basis, for tax purposes, isn’t $200,000 – it’s $250,000.

Here’s what all of that means: for tax purposes, the capital gain on the home sale was $640,000 (the adjusted sales price) minus $250,000 (the home’s actual basis price). That equals $390,000, well below the amount that triggers capital gains taxes for heads of households or married couples who file jointly. There’s even a benefit for single filers, since their $250,000 exemption means they’ll pay capital gains taxes on just $140,000 of their profit.

There’s more fine print involving home depreciation and insurance losses; it’s mostly important to those who use part of their house as a home office or rent the house to tenants. There are also partial capital gains exemptions available to those who haven’t lived in the house for two years because of personal circumstances like health issues, job change or divorce. But this was complicated enough. If you need to know more, ask the professional who does your taxes.

There’s a much more important question for our purposes. If you sell your house and your profit ends up “too high” – is there a way to avoid capital gains tax when selling your home?

Bottom Line: Home sellers only have to pay capital gains taxes once they’ve made more than $250,000 or $500,000 profit (depending on tax filing status). When figuring out if you have to pay capital gains tax on the sale of your house, though, you don’t simply take the final selling price and subtract what you originally paid for it. You’re entitled to deduct all sorts of expenses, which usually makes the taxable profit on the home much lower.

Avoiding (or Reducing) Capital Gains Tax When Selling Your Home

You’ve already learned several of the ways to lower or eliminate capital gains taxes on a house sale. Deducting all legal selling expenses, and increasing the home’s basis by adding the cost of all legally-allowable home improvements, are big steps in the right direction. For many home sellers, that may be enough to completely eliminate capital gains taxes.

What else can you do?

We wouldn’t suggest reducing your home’s listing price simply to make sure you won’t incur capital gains taxes. You’ll end up on the losing end; selling a house for $20,000 less just to save $2,000 in taxes isn’t a smart move.

There are better strategies to consider.

Offset the Capital Gain with Other Losses

At the start of this discussion, we mentioned that these taxes are paid on a taxpayer’s total capital gains for the year. That doesn’t matter to people who aren’t investors. They usually don’t have to worry about capital gains taxes until they sell their house.

However, those who hold stocks, bonds, properties or other types of investments may be able to slightly reduce, or even eliminate, their capital gains liability.

Here’s an example. Let’s say a homeowner sells their house for a profit just large enough to cross the capital gains tax threshold. The law allows taxpayers to deduct up to $3,000 of long-term capital losses each year; that would offset $3,000 of their capital gain on the house. In this case, the homeowner would avoid paying any tax at all. Even if they still owe capital gains tax after the offset, they’d still end up paying less tax.

How would you take advantage of this strategy?

Investors who’ve already experienced at least $3,000 in long-term losses for the year don’t have to do anything else. They already have enough of a loss to offset $3,000 of the capital gain on their home.

Investors without capital losses for the year can simply sell stocks or other properties on which they’re underwater, as long as they’ve held the investments for at least two years.

This approach doesn’t provide much savings – unless you’re close to the borderline between incurring or not incurring capital gains taxes. In that case, it can save you a lot of money.

Divide the Ownership of the House Before Selling

Let’s consider a married couple thinking about selling their home, but they’re concerned that the price they can get for the house would put them several hundred thousand dollars over the $500,000 threshold. One important additional factor: they have an adult daughter who’s been living at home for at least two years out of the last five.

That couple could do some advance planning that would let them avoid the capital gains tax. By gifting one-third of the house to their daughter, they’d only own two-third of the property. When it’s sold, they’d only be liable for two-thirds of the capital gain; their daughter would be responsible for the tax on the final third.

As long as the total capital gain is less than $750,000, the couple is below the $500,000 threshold and the daughter is below the $250,000 limit. None of them has to pay capital gains tax on the sale of the home.

Be sure to consult your tax advisor, though, before trying this or any other tax-avoidance strategy.

Avoiding Capital Gains Taxes for Property Investors

These approaches won’t help most people who buy a house, live in it for a while, and then sell it. But there are several ways that property investors can avoid paying capital gains taxes. In some cases, they can avoid the taxes virtually forever.

  • Like-Kind Exchange: Officially known as a 1031 exchange, this strategy allows you to defer capital gains taxes when you sell an investment property – by immediately purchasing another one with the proceeds. Tax law allows you defer any capital gains on the initial sale until the second property is sold. Investors who do that again and again can theoretically avoid paying taxes on the proceeds for decades or even longer.
  • Self-Directed IRAs: You can do much more with an individual retirement account than purchase mutual funds. With a self-directed IRA, or SDIRA, you can invest in nearly anything, including real estate. Perhaps best of all, when investment properties held in an SDIRA are sold, the profits aren’t considered capital gains so they’re not taxed. (Naturally, you’ll eventually pay income tax on anything you withdraw from the IRA after retirement.)
  • Moving into an Investment Property: The owner of an investment property can lower the capital gains tax that would be due when it’s sold, by moving into it for a while. That allows them to claim the house as a primary residence, and benefit from the standard rules governing capital gains from home sales.

Again, be sure to consult with your tax advisor before using any of these methods to avoid capital gains taxes.

Bottom Line: All homeowners can limit or avoid capital gains taxes on the sale of their house by making sure they claim all of the legal deductions they’re entitled to. Some may benefit from applying (or finding) capital losses to offset some of the capital gains, or dividing the home’s ownership so none of the owners receive enough of the profits to be liable for capital gains taxes. There are other strategies which may work for some owners of investment properties, but none should be used without consulting tax professionals.

How to Avoid Capital Gains Tax When Selling Your Home FAQ

Q: I’ve never even heard of paying capital gains taxes when you sell a house, and I’ve sold several. Am I going to hear from the IRS someday, claiming I owe back taxes?
A: It’s extremely unlikely you have anything to worry about. Unless you make a very big profit on a home sale, capital gains taxes don’t kick in. Chances are that whoever prepared your taxes didn’t mention anything to you, because you weren’t anywhere near the threshold where you’d have to pay this tax. If you prepared your own taxes, now you know about homes and capital gains – so you can be more careful next time.

Q: I’m single and have lived in my house for five years. If I end up with a $300,000 profit (after all deductions) when I sell the house, does that mean I owe capital gains tax on all $300,000, or just on the extra $50,000 after $250,000 is excluded?
A: We have the answer you want to hear. An exclusion means you don’t pay any capital gains tax on that amount, whether you qualify for $250,000 or $500,000. You’d only have to pay tax on the “extra” $50,000.

Q: We have a home up north, and a winter home in the south. Since we live in the winter home four months each year, which one qualifies as our primary residence for purposes of the capital gains tax?
A: You’d have to clarify this with your tax advisor. It depends on several factors, including whether you actually lived in both houses for part of every year, and the amount of time you spent in each house per year (called “qualifying time”) – and the calculations must go all the way back to 2009, when the capital gains tax law was changed. If all the boxes are checked, you should be able to get a portion of the exclusion for each house when it’s sold.

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