Capital Gains Exceptions That Can Lower Your Taxes

When you sell an asset like stocks or real estate for more than you paid, the profit is a capital gain. This gain is subject to federal and sometimes state taxes, with the rate depending on how long you held the asset and your income. The Internal Revenue Code, however, provides several established rules that can legally reduce or even eliminate this tax liability. These provisions cover specific situations, from the sale of a primary home to certain investments and charitable activities.

The Home Sale Exclusion

One of the most widely used capital gains exceptions is the home sale exclusion, governed by Internal Revenue Code Section 121. This rule allows single filers to exclude up to $250,000 of profit from the sale of their primary residence, while married couples filing jointly can exclude up to $500,000. If your gain falls within these limits, you will likely owe no capital gains tax.

To qualify, you must meet two primary tests. The Ownership Test requires you to have owned the home for at least two of the five years leading up to the sale. The Use Test requires you to have lived in the home as your main residence for at least two of the five years before the sale. These two years do not need to be continuous.

A taxpayer can claim this exclusion only once every two years, a rule that prevents the frequent, tax-free flipping of residences. The exclusion applies only to your main home, not to second homes or vacation properties. In some situations, you may qualify for a partial exclusion if you do not meet the full two-year requirements. The IRS allows a prorated exclusion if the sale is due to a change in workplace location, a health issue, or an unforeseen event like job loss or a natural disaster.

Transferring Assets Through Gifting or Inheritance

The way an asset is transferred has different consequences for capital gains taxes. The difference centers on the asset’s cost basis, which is the original value used to calculate the taxable gain upon its sale.

When you give someone an appreciated asset as a gift, the recipient’s tax basis is the same as yours, which is known as a “carryover basis.” The capital gain is not eliminated but is deferred until the recipient sells the asset. For example, if you bought stock for $20 per share and gift it to your child when it is worth $100, their cost basis is your original $20. If they later sell the stock for $110, they will owe capital gains tax on a $90 gain.

In contrast, when an individual inherits an asset, they receive a “stepped-up basis.” This means the asset’s cost basis is reset to its fair market value on the date of the original owner’s death. This step-up erases the capital gains tax liability on all appreciation that occurred during the decedent’s lifetime. Using the same stock example, if the shares were worth $100 on the day you passed away, your heir’s basis becomes $100. If they sell it later for $110, they would only owe capital gains tax on the $10 of appreciation that occurred after they inherited it.

Specialized Investment Exclusions and Deferrals

Several capital gains exceptions are tied to specific types of investments designed to encourage growth in particular economic sectors.

Qualified Small Business Stock (QSBS)

Under Internal Revenue Code Section 1202, investors may be able to exclude 100% of the capital gains from the sale of Qualified Small Business Stock. The stock must have been issued by a domestic C-corporation with gross assets of $50 million or less at the time of issuance. The investor must have acquired the stock at its original issuance and held it for more than five years.

Additionally, the corporation must be an active business, with at least 80% of its assets used in a qualified trade or business. The amount of gain that can be excluded is limited to the greater of $10 million or 10 times the investor’s basis in the stock.

Opportunity Zones

The Opportunity Zone program offers a way to defer and potentially reduce capital gains taxes. An investor can roll over capital gains from a prior sale into a Qualified Opportunity Fund (QOF) within 180 days of realizing the gain. A QOF is an investment vehicle that holds at least 90% of its assets in a designated low-income community.

The tax on the original capital gain is deferred until the QOF investment is sold or December 31, 2026, whichever comes first. If the QOF investment is held for at least 10 years, any appreciation on the QOF investment itself becomes permanently tax-free.

Like-Kind Exchanges

A like-kind exchange, governed by Internal Revenue Code Section 1031, allows an investor to defer capital gains on the sale of business or investment real estate by exchanging one property for another of a “like-kind.” This is a deferral, not a permanent exclusion, as the tax is postponed until the replacement property is sold for cash.

The rules for a 1031 exchange are strict regarding timelines. Once the initial property is sold, the investor has 45 days to identify potential replacement properties in writing. The purchase of the replacement property must then be completed within 180 days of the original sale. This strategy is now limited to real property.

Using Offsetting Strategies to Reduce Taxable Gains

Taxpayers can use proactive strategies to manage their overall capital gains liability by timing the sale of assets or using them for charitable purposes.

Tax-Loss Harvesting

Tax-loss harvesting is the practice of selling investments at a loss to offset capital gains from profitable sales. The process follows specific ordering rules: short-term losses must first offset short-term gains, and long-term losses must first offset long-term gains. Any net losses remaining can then be used to offset the other type of gain.

If you have more capital losses than gains in a year, you can use up to $3,000 of the net loss to reduce ordinary income, such as wages. Any remaining losses can be carried forward to future tax years. This strategy is subject to the “wash-sale” rule, which prevents claiming a loss if you purchase a “substantially identical” security within 30 days before or after the sale.

Donating Appreciated Assets

Donating long-term appreciated assets directly to a qualified charity can provide a dual tax benefit. When you donate an asset like stock held for more than one year, you avoid paying the capital gains tax that would have been due if you had sold it. You can also claim a charitable deduction for the full fair market value of the asset at the time of the donation. The deduction for appreciated property is limited to 30% of your adjusted gross income (AGI) for the year, with a five-year carryforward for any excess contributions.