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What Taxes Do You Pay When Selling a House?

August 16th, 2023 at 11:00 am

Selling a house is one of the biggest steps in a person’s life, one that not everyone will experience. The process of pricing your home to sell comes with the potential joy of making a sum of money, along with the thrill of moving into a new home elsewhere.

While selling a home is extremely exciting, the process is a bit more complicated than you might think. Something that home sellers don’t often think about is taxes on their sold properties, particularly capital gains taxes. This is why many sellers opt to hire a REALTOR®. Learn more about what property sales taxes in California do you will pay when selling a house and how you can minimize or even avoid those taxes.

Understanding capital gains taxes

What taxes do you pay when you sell a house? You get taxed for any money you make, and that includes profits on a sold home. Capital gain refers to any profits that come from the sale of an asset, including stock shares, a business, a piece of land, and a home sale. Essentially, if you sell your home for more than your initial purchase price, you made a capital gain.

Income from capital gains is taxed at a specific rate based on your taxable income and your filing status (single, married, etc.). In 2020, for example, capital gains tax rates were 0 percent, 15 percent, and 20 percent on assets held for over a year.

Capital gains tax exclusion

The good news about home sales: most homeowners who sell their homes are granted a capital gains tax exemption thanks to the Taxpayer Relief Act of 1997. In fact, the large majority of people who sell their homes don’t even have to report a home sale transaction to the IRS, though much of this also depends on how long you have lived in the home and the actual profits made.

Primary residency

To be included in this tax exemption, the home that you sold must be considered a primary residency. Under the rules of the IRS, a home is considered your primary residence for at least two out of the last five years.

This can even apply to a rental property as the two years do not have to be consecutive. For example, you may have a home that you lived in for the first year before converting it to a rental property for the next three years. At the end of the three years, the tenants move out, and you move back in for another year. That makes the property a primary residency.

Profit made on sale

In terms of profit, the IRS allows you to exclude up to $250,000 of your profit on the sale if you are single. If you are married and filing a joint return, that exclusion amount goes up to $500,000. For example, if you are single and made a profit of just $200,000 on your home sale, you wouldn’t have to pay any taxes on that amount.

On the other hand, if you made $600,000 on a home sale and file jointly with your spouse, the tax exclusion would apply to $500,000 of that amount. This means that you would have to still pay taxes on the leftover $100,000.

Timing

You can apply this exclusion to essentially every home sale. However, you cannot apply this exclusion on home sale gains within two years prior of the sale. For example, if you sold a home one year ago and applied the exclusion, you would not be able to apply the exclusion to a home sale this year.

Disqualifications for the exclusion

The above tax exclusion generally applies to everyone. However, there are some situations when the exclusion does not apply, requiring you to pay taxes on all of your gains.

However, even within these disqualifying factors, you can find some room to make an exclusion. For example, even if you have not lived in the property for two of the last five years, the IRS will make exceptions for those with disabilities and those who are serving in the military, Foreign Service, or the intelligence community.

Special circumstances

Even if you do not meet the requirements, there are special circumstances when you may still qualify for the tax exclusion or even a partial exclusion.

Reduced exclusion

Even if you do not pass the two-out-of-five-year requirement, you may still be eligible for a reduced exclusion. A reduced exclusion simply means that you get less than the regular $250,000 or $500,000 exclusion.

Reduced exclusions are available to those who are forced to sell their homes prior to living in the property for two out of five years. The circumstances may include:

This means that, if you have to move because you suddenly gave birth to twins, the IRS would not penalize you for it.

Paying capital gains taxes

If you are completely ineligible for the exclusion, you will have to pay taxes on all or part of the sale of your home. Start by figuring out your capital gains tax rate. If you owned the property for less than a year, you can look at short-term capital gains tax rates. This rate is the same as your ordinary tax rate (i.e., your tax bracket).

If you owned the property for longer than one year, you will have to pay long-term capital gains tax rates. These rates depend on your filing status and income. Many people actually qualify for a 0 percent tax rate, while everyone else pays 15 to 20 percent.

Minimizing or avoiding capital gains taxes

If you are not eligible for the full capital gains tax exclusion, you can take some steps to avoid or reduce the amount that you pay in property tax.

Use a 1031 exchange

Mentioned above, a 1031 exchange (also known as a like-kind or like-for-like exchange) can help you to avoid paying taxes on a home sale. By reinvesting the proceeds of a sale into a similar property, you can actually defer taxes on those gains. Just remember that deferring taxes is not the same as completely eliminating the taxes.

Check for exceptions

If you sold the house based on an unforeseen event, whether that’s employment or health, you may still be able to exclude some of the gains from your home sale. Check the full list of IRS exceptions.

Keep track of home improvements

All of the improvements you made to your home over the years factor into the cost basis (essentially what you paid for your home). This can reduce the actual profits that you’ve made, which can keep your capital gains taxes down. This includes:

Hold out for longer

If at all possible, try to hold out from selling your home for as long as you can. Part of that is getting to the two-year threshold for the exclusion requirements, but even if you don’t qualify for the exclusion, it’s better for your tax rate. Long-term capital gains tax rates are significantly lower than short-term tax rates, so try to hold the property for at least one year before selling.

Common tax-related difficulties to avoid

1. Ignoring capital gains tax implications

One of the most common mistakes you can make when selling your home is disregarding capital gains tax implications. Capital gains tax is applied to any profits made from the sale of an asset, including real estate properties. If you don’t know the details of this tax and how it could apply to you, it may lead to unexpected tax liabilities. 

Advice: Educate yourself on how capital gains tax is calculated and its applicable rates based on your taxable income and filing status.

2. Overlooking the primary residency requirement

Many homeowners may not be aware of the Taxpayer Relief Act of 1997, which grants a capital gains tax exclusion for most homeowners selling their primary residences. Do your research to learn more about this because if you’ve lived on the property for at least two of the last five years, you could qualify for this exclusion. 

Advice: Keep thorough records of your occupancy and ensure that you meet the primary residency requirement to take advantage of the tax exclusion. If you converted your home into a rental property, understand that certain exceptions may apply.

3. Failing to consider special circumstances

There are instances where the standard tax exclusion does not apply. As an example, if you haven’t lived on your property for two out of the last five years due to health, employment or other unexpected events, you may be eligible to qualify for a  reduced exclusion. 

Advice: Familiarize yourself with the IRS exceptions and consult a tax professional to explore potential exclusions or deductions applicable to your unique situation.

4. Inadequate record-keeping of home improvements

You can reap the benefits of home improvements not only while you’re living in the home to enjoy them, but also when selling your house. Home improvements can impact your cost basis, which determines the profits made from the sale of your home. It’s always recommended to keep clear records of home improvements, including remodels, expansions or upgrades since that could lead to higher taxable gains. 

Advice: Maintain detailed records of all home improvements, including receipts and invoices, to accurately calculate your cost basis and reduce your taxable income.

Additional tax matters

Addressing inheritance tax and estate tax

In addition to capital gains tax, you may encounter inheritance tax and estate tax implications when selling a house. These may vary depending on the value of the property, as well as the relationship between the deceased and the beneficiary.

Advice: Understand the specific inheritance tax and estate tax regulations in your state, and consider consulting an estate planning attorney to navigate these complex matters.

The impact of property depreciation on taxes for investors

Investors who sell their rental property may face additional tax considerations, such as depreciation recapture, which involves recapturing the depreciation deductions taken during the ownership of the property.

Advice: Consult a tax professional with expertise in real estate investment to determine the tax implication of selling an investment property and explore strategies to minimize tax liabilities.

Conclusion

Taxes on a sold property can get confusing, and if you don’t know what you’re doing, you may end up paying penalties and fees on top of the owed taxes. Studying common tax-related pitfalls and making sure you understand state-specific tax considerations as essential steps to help ensure a successful and financially rewarding transaction. If you are selling your home or are a first time home buyer in Southern California, our team of California real estate agents at Berkshire Hathaway HomeServices California Properties can guide you through the whole process and cover all your bases to ensure your peace of mind. Visit one of our Berkshire Hathaway office locations to learn more.

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Reviewed by Dean Stalter
Dean Stalter is proud to be the Broker of Record for Berkshire Hathaway HomeServices California Properties. He represents the nearly 3,000 agents that make up the company’s presence in Southern California, spanning Santa Barbara down to San Diego. An award-winning real estate veteran, Dean is a great subject matter expert in all things real estate.

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