Home values have skyrocketed over recent years in many markets across the country. Homeowners who decide to sell anytime can potentially make a big profit if they have a lot more equity in the home compared to what is still owed on their mortgage.
But there are circumstances under which any profits made after a sale may be subject to capital gains taxes.
Capital gains tax is applicable to any profits – or capital gains – that are realized upon the sale of real estate minus the cost basis. The cost basis is the amount that you paid for your home plus any monies you paid to make repairs, maintain the property, and the associated costs of selling.
Not all properties are subject to these types of taxes, but many other are. It’s important to know if your particular sale would qualify you to pay any capital gains taxes before you place your home on the market.
Here are important facts that all sellers should know about capital gains taxes before they sell.
1. Exemptions Are Only Applicable to Primary Residences
If the home you are selling is not your main residence, odds are any gains will be taxed when you sell. The IRS will want to make sure that the home you are selling is your main residence, and if it isn’t, capital gains taxes will likely be applied if you profit from the sale.
2. How Long You Owned and Lived in the Home Matters
Not only does the home have to be considered your main residence according to the IRS, it must also have been your primary home for a minimum of two out of the five-year period before you sell, which would make it a long-term asset on your books. Any less than that would deem the home a short-term asset. Capital gains on short-term assets are much higher compared to long-term assets.
However, you don’t necessarily have to have lived in the home for two straight years. You could live in the home for one year, move out for a year, then move back in for another year, just as long as it totals two years within the five years before you sell.
3. You Can Take Advantage of a Capital Gains Tax Break Many Times
There is no limit on how many times you can be excluded from having to pay capital gains. As long as you own and live in the home as your primary residence for two out of the five years before selling, you can essentially repeat the process over and over again without having to pay any capital gains taxes on any profits you make.
4. Your Maximum Deduction is $250,000
The IRS will only allow homeowners to be excluded from paying capital gains taxes up to a maximum profit of $250,000. If you make more than this amount in profits when you sell, that amount over and above the $250,000 will be taxed by the IRS.
This number jumps to $500,000 for married couples. However, they don’t have to co-own the property together — just one spouse must own the home for two of the last five years in order to qualify for this exception. If the couple divorces before the two years is up and moves out, the homeowner spouse can only claim part of that amount based on how long they actually owned and stayed in the home. For instance, the owner may claim half of the $500,000 if they only lived in the home for one out of the two years.
4. A Loss on the Sale Cannot be Deducted
When you sell a property for less than its cost basis, you will experience a capital loss. If you suffer a loss when you sell your home, the IRS won’t allow you to deduct these losses from your taxable income. The exclusion is only applicable to capital gains.
5. You Don’t Have to Report Any Gains in Most Cases
If you and your home qualify for exemption from capital gains taxes, then you don’t have to report any gains to the IRS. If only part of the gain can be excluded, however, you may have to report your gains.
6. You May Be Excluded From Capital Gains Taxes For Unforeseen Circumstances
There may be times when you will be forced to sell your home before the two out of the five years is up before selling. In certain cases, the IRS may grant you a full exclusion from the taxes on an early sale. Some of these situations may include death, job relocation, loss of a job, damage to the home as a result of a natural disaster or act terrorism, or seizure of the home from the government.
The Bottom Line
Having to pay capital gains taxes on the sale of your home can be an unpleasant surprise if you aren’t expecting them. That’s why it’s important to get informed about these and other types of taxes that may apply to you. While the information in this article is meant to enlighten you on the potential to pay capital gains taxes and the circumstances that may exempt you from them, it’s in your best interests to speak with your tax professional in order to remain compliant with the IRS.