When Do You Have to Pay Capital Gains Tax on a House Sale?

Selling a house can come with significant financial implications, including potential capital gains taxes. Whether taxes are owed depends on factors such as how long the property was owned and used as a primary residence, its purpose, and available exemptions.

General Exclusion Rules

The IRS allows homeowners to exclude a portion of their capital gains when selling a primary residence, provided they meet ownership and use requirements. Under the Section 121 Exclusion, individuals can exclude up to $250,000, while married couples filing jointly can exclude up to $500,000. To qualify, the seller must have owned and lived in the home for at least two of the last five years before the sale. These years do not need to be consecutive, providing flexibility for those who may have relocated temporarily.

This exclusion applies only to a primary residence, meaning the home where the seller has spent most of their time. If the property was used as a rental or vacation home for an extended period, the exclusion may be reduced or eliminated. Additionally, it can only be used once every two years, preventing homeowners from repeatedly avoiding taxes through frequent sales.

A partial exclusion is available if the homeowner sells before meeting the two-year requirement due to specific circumstances such as job relocation at least 50 miles away, health-related moves, or significant life events like divorce or natural disasters. The exclusion is prorated based on the time lived in the home.

Taxable Gains for Secondary Properties

Second homes, investment properties, and vacation residences do not qualify for the Section 121 Exclusion, meaning any profit from their sale is subject to capital gains tax. The taxable amount is determined by subtracting the adjusted cost basis from the sale price. The adjusted basis includes the original purchase price plus capital improvements but excludes routine maintenance and repairs.

Capital gains on secondary properties are classified as short-term or long-term, depending on how long the property was held before selling. If owned for one year or less, the gain is taxed at ordinary income tax rates, which can be as high as 37% in 2024. If held for more than a year, the gain qualifies for long-term capital gains tax rates, which range from 0% to 20%, depending on taxable income. For example, a single filer with taxable income below $47,025 pays 0%, while those earning over $518,900 are taxed at 20%. Most sellers fall into the 15% bracket, which applies to incomes between $47,025 and $518,900.

Owners of rental properties must also consider depreciation recapture. If depreciation deductions were claimed, the IRS requires these amounts to be taxed at 25% upon sale. For example, if a rental property owner deducted $50,000 in depreciation, they would owe $12,500 in taxes on that amount, in addition to capital gains taxes on the remaining profit.

A 1031 exchange allows sellers to defer capital gains taxes by reinvesting proceeds into a like-kind property within 180 days. To qualify, a replacement property must be identified within 45 days, and the new purchase must be of equal or greater value. Any portion of the proceeds not reinvested is taxed as a boot, subject to capital gains tax.

Exceptions That May Trigger Taxes

Certain situations can result in capital gains tax liability even when an exclusion was expected. Inherited properties receive a stepped-up basis, meaning the cost basis is adjusted to the fair market value at the time of the original owner’s death. While this reduces taxable gains, selling the property for more than its stepped-up value can still result in capital gains tax.

Divorce settlements can also create unexpected tax liabilities. When one spouse receives sole ownership of a previously jointly owned home, their cost basis remains unchanged. If they later sell the property, their exclusion is limited to $250,000 rather than the $500,000 available to married couples, which can lead to taxes if the home has appreciated significantly.

Homeowners who convert a primary residence into a rental property before selling face additional tax consequences. The IRS applies non-qualified use rules, reducing the amount of gain eligible for exclusion based on the period the home was used as a rental. If a homeowner lived in a house for three years, then rented it out for two before selling, only 60% of the gain would be eligible for exclusion, with the remaining 40% taxed as a capital gain.

Reporting and Payment Requirements

Capital gains from a home sale must be reported to the IRS, even if no tax is owed. If the gain exceeds the exclusion limits or the property does not qualify for any exemptions, the seller must report the transaction on Schedule D (Form 1040) and Form 8949, detailing the purchase date, sale price, and adjusted basis. The IRS cross-references this information with Form 1099-S, which is issued by the closing agent if the sale meets reporting thresholds. Sellers can avoid receiving this form by certifying to the agent that the entire gain is excludable, but providing false information can result in penalties.

If the gain is substantial and no taxes were withheld, the seller may need to make estimated tax payments using Form 1040-ES to avoid underpayment penalties. These payments are due quarterly—April 15, June 15, September 15, and January 15 of the following year. Failure to submit adequate estimated payments can lead to IRS penalties calculated based on the shortfall and the federal short-term interest rate plus 3%.