When a home sale will lead to capital gains

With home prices climbing, some sellers are concerned about capital gains taxes. If you bought your home more than 20 years ago and/or you live in a hot market, it’s possible your home value has increased to the point where capital gain taxes would kick in.

Currently, if you sell your primary residence you can keep up to $250,000 in capital gains tax free. If you’re married, you can keep up to $500,000 in gains.

Any significant improvements you’ve made on the home can decrease your tax calculations. For example, let’s say you purchased the home for $150,000. Over the years, you spent another $250,000 in remodeling and updates. So, the basis for the house is now $400,000.
Your house sells for $1 million. You have realtor fees and closing costs of 6%, or $60,000, which you add to the basis. If you subtract $460,000 from $1 million, that means you’re realizing $540,000 in capital gains. You’d keep the $500,000 tax free under the exemption and owe long-term capital gains on the remaining $40,000.

Be aware, you may still owe state taxes on the sale and, potentially, a net investment income tax of 3.8% if your adjusted gross income exceeds a certain threshold (e.g., $250,000 for married couples filing jointly).

Home improvements. You also need to know that routine maintenance and repairs don’t count toward increasing your home’s basis. So painting the house won’t reduce your capital gains taxes, but putting on a new roof, replacing windows, or installing hardwood flooring will. (IRS publication 523 “Selling Your Home” includes a list of eligible improvements.) It’s important to keep good records of all the improvements you make to your home as every dollar could reduce your taxes one day.

The two-year rule. To be clear, the home must be your primary residence for at least two of the past five years to qualify for the capital gains exemption. That means rental properties and vacation homes don’t count. Conventional advice suggests you can just move into a rental or vacation home and make it your primary residence for two years to avoid capital gains, but it’s not really that simple.
If the property is a rental, for example, you’ll still need to recapture a percentage of the depreciation you took over the years. Likewise, since 2009, the IRS requires adjustments for ownership periods categorized as “non-qualifying use.” That means if you move back in for two years, after renting for eight years, your prorated exclusion limit is just 2/10ths of the gain. There are a lot of variables here, so consult an experienced advisor before planning a move for “tax saving” purposes.

1031 exchange. If the property is a rental and you want to sell, you may be able to set up a 1031 tax deferred exchange. That allows you to defer capital gains taxes by investing the proceeds from one property into a new investment property.

Know that 1031 exchanges can be complicated and there are strict timelines and rules you need to follow to execute a qualifying exchange. Again, get professional advice early, before you list your property for sale.