Ready to sell your home? What you need to know about tax implications

Published on Apr 25, 2022

Ready to sell your home? What you need to know about tax implications

If you’ve been avidly reading the headlines on the soaring real estate market, you might be thinking that now is the time to cash in…sell your spacious home and move into a smaller place you can rent or own. One issue that many sellers often don’t completely understand is the tax implications of a home sale, particularly if their property has risen sharply in value. Here is what you need to know about selling a home and the potential tax liability.

Capital gains taxes explained

Whenever you sell an investment, you have to pay taxes on the profit you made. Since real estate is technically an investment, even though it also serves an important purpose as your shelter, it is therefore subject to capital gains.

There are two types of capital gains: short-term, which is levied on investments you’ve held less than a year, and long-term gains, which are those you’ve held more than a year. Income tax rates are set by the Internal Revenue Service (IRS) and vary based on your income and tax filing status.

In today’s market, many homeowners may find their home has appreciated in value from when they bought it, especially if they have owned it a long time. That means they could be subject to a hefty bill when paying taxes on that large profit. Fortunately, most homeowners are exempt. Read on to find out more.

Will I be exempt from capital gains taxes?

Unlike other types of investments, such as stocks or bonds, real estate is often exempt from capital gains. The key is that the property you are selling must be your primary residence, rather than a secondary residence, like a vacation home, or a property you purchased specifically for investment purposes, such as a rental.

The IRS determines if it’s a primary residence based on how long you have lived there – it must be 24 months out of the previous five years, although they don’t have to be consecutive. If you own more than one residence, you can prove which one was your primary residence based on which address you used for voting or filing taxes or where your driver’s license or official identification is from.

Homeowners who relocate frequently can rest easy as you can claim this exemption every two years.

It’s important to note that there is a limit to the exemption, which currently is $250,000 if you are single and $500,000 if married. So if you have held your home for decades and have seen its value skyrocket, you still may owe some capital gains on the profit you made.

Another way to reduce the capital gains bill is to deduct the property’s “cost basis.” To do this, you start with the original purchase price of the property, then add up the cost of home improvements and other money you have invested that helped its value grow, including desirable enhancements like kitchen upgrades or new outdoor living space, or important repairs such as a new roof. 

The benefit of calculating the cost basis is that the higher this figure, the lower the number used to derive your capital gains taxes. For example, if the profit from the sale is $500,000, but your cost basis is $300,000, your taxes will then be calculated based on $200,000. Be sure to talk to a knowledgeable tax professional to ensure you are calculating cost basis appropriately.

Other ways to offset capital gains taxes

Home sellers may still have recourse to reduce their capital gains bill even if the exemption explained above doesn’t apply – for example, if the property has not been your primary residence for at least two years.

The most common way is through a “1031 exchange,” which allows you to roll the profits from one investment property into another “like-kind” property, which the IRS defines as ones with similar nature or character, such as one rental home for another. This will defer the capital gains tax, though not eliminate it.

Another option may be to offset capital gains through any losses you might have incurred, perhaps on the sale of stocks.  Again, it’s wise to discuss these strategies with a tax professional.

As the housing market takes off, it can be more tempting than ever to want to realize a big gain by selling your home. Just make sure you take into account the effect it may have on your taxes, so you aren’t unpleasantly surprised with an unexpected bill come tax time.

At Valley Bank, we can connect you with resources for all your financial planning needs.  Contact us today to learn more.


Disclaimer: All content is for educational purposes only and does not constitute tax advice.

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