Do I Pay Capital Gains Tax on My House Sale?

When you sell your home for more than your original cost, the profit may be subject to capital gains tax by the Internal Revenue Service (IRS). This gain is treated as taxable income, meaning a portion of your proceeds could be owed. The amount of tax depends on several factors, including the size of your profit and how long you have owned and lived in the home. While the sale of a primary residence often does not result in a tax bill due to available exclusions, understanding the regulations is necessary to determine your financial outcome.

The Primary Residence Exclusion

The primary residence exclusion, or Section 121 exclusion, allows sellers to exclude a substantial amount of profit from their taxable income. To be eligible, you must satisfy two conditions: the ownership test and the use test. The ownership test requires you to have owned the home for at least two years during the five-year period ending on the sale date. 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.

The two-year periods for the ownership and use tests do not need to be continuous or simultaneous. For instance, you could live in the home for two years and then rent it out for three years before selling. As long as you meet both two-year requirements within the five-year window before the sale, you can qualify for the exclusion. This flexibility accommodates various life circumstances.

The exclusion amount is up to $250,000 of gain for a single filer and up to $500,000 for a married couple filing jointly. To qualify for the $500,000 exclusion, at least one spouse must meet the ownership test, and both must meet the use test. Additionally, neither spouse can have used the exclusion on another home sale within the two years before the current sale.

You may be able to claim a partial exclusion if you do not meet the full two-year requirements but sell due to a change in employment, a health issue, or other unforeseen circumstances as defined by the IRS. These circumstances can include divorce, the death of a spouse, or having multiple children from one pregnancy. In these situations, the exclusion is prorated based on the portion of the two-year period you met. For instance, meeting the requirements for one year could allow a single filer to exclude up to $125,000.

Calculating Your Home’s Basis

To determine your profit, you must first calculate your home’s basis, which is its value for tax purposes. The starting point is the original purchase price, which is then adjusted for certain costs to create the “adjusted basis.” A higher adjusted basis is beneficial because it reduces your calculated gain and potential tax liability.

Your basis increases with capital improvements, which are projects that add value to your home, prolong its life, or adapt it to new uses. Examples include adding a new room, finishing a basement, or remodeling a kitchen. These are distinct from simple repairs, like painting a room or fixing a leak, which do not increase your basis.

Other costs that increase your basis include certain settlement fees from your original purchase and assessments for local improvements, like new sidewalks. These costs can include:

• Title insurance
• Legal fees
• Recording fees
• Survey costs

Conversely, your basis can decrease. The most common reason for a basis reduction is claiming depreciation deductions, which occurs if you used part of your home for business or rented it out. Any depreciation you were entitled to claim reduces your basis, which increases your gain when you sell.

Determining Your Taxable Gain

To determine your gain, start with the final sale price of the home. From this amount, subtract any selling expenses you paid, such as real estate agent commissions, advertising fees, and legal fees. The result is the “amount realized” from the sale.

Next, subtract your adjusted basis from the amount realized to find your total capital gain. You then apply your available primary residence exclusion. Any gain that exceeds your exclusion limit is considered taxable and must be reported.

The tax rate on your gain depends on how long you owned the home. If you owned it for more than one year, the profit is a long-term capital gain, taxed at rates of 0%, 15%, or 20%, depending on your income. If you owned the home for one year or less, the profit is a short-term capital gain, taxed at your higher ordinary income tax rates.

A special rule applies if you claimed depreciation on the property. The portion of your gain equal to the depreciation you took is subject to a “depreciation recapture” tax. This part of the gain is not eligible for the primary residence exclusion and is taxed at a maximum rate of 25%.

Reporting the Sale on Your Tax Return

You must report the sale to the IRS on your annual tax return. This is necessary even if your entire gain is excludable, especially if you receive a Form 1099-S, Proceeds From Real Estate Transactions. This form reports the gross proceeds of the sale to the IRS, so you must account for it on your return.

The primary form for this is Form 8949, Sales and Other Dispositions of Capital Assets. On this form, you will detail the specifics of the transaction, including the property description, acquisition and sale dates, sales price, and your cost basis. Use information from your settlement statements from both the purchase and sale to complete this form.

The totals from Form 8949 are transferred to Schedule D, Capital Gains and Losses, which summarizes your capital gain and loss activity. This final figure from Schedule D is then carried over to your main tax form, the Form 1040. This process integrates the transaction into your overall tax liability for the year.