Another very popular question we get asked regularly, let’s dive in and learn.
Understanding how capital gains tax affects your profit when you sell your home can be challenging. According to IRS, it depends on time and money, and it’s not that simple of course.
Capital gains tax is a fee you pay when you sell your home for more than you paid for it. But when you sell, the IRS rule states: Exclusion of gain from the sale of the principal residence allows you to make a certain amount of tax-free profit before the capital gains tax calculation. Up to $250,000 in profit if you’re a single owner and up to $500,000 as a couple.
As a homeowner there are two ways to avoid the capital gains tax: ownership and use. That means you must have owned your home for two of the previous five years, living in it as your primary residence. No matter the purchase or sales price, if you make a profit when you sell and didn’t own it for two years, there will be tax to pay.
How does the IRS calculate the profit? They start with the purchase price of your home and add in other expenses you paid when you bought it. These include fees for owner’s title insurance, recording the deed, and county/city transfer tax basically closing costs. If the seller paid any of these for you or paid a fee to lower your interest rate (buying points), it’s an allowed deduction from the purchase price.
You can also add the cost of renovations to the original cost of your home. Basically if you spend money on the house to improve it and increase its value, you can add those costs to the total. Here are a few examples of what those might be:
- Additional living space (square footage)
- remodeling bathrooms or kitchen
- new roof
- interior or exterior painting
Make sure you keep all the records from the purchase of your home and the records of any major remodel or home improvement projects.
When it’s time to sell your home, you can deduct certain expenses from the sales price when calculating your net profit. The real estate commission and any closing costs you cover for the buyer are some of the allowed deductions from the total profit.
Once the net profit on the sale is calculated. If that amount still doesn’t cover all the profit on the sale, the remaining portion is subject to long-term capital gains. Short-term capital gains are only applicable for property owned under one year.
Let’s look at a scenario, a married couple buying a home in 2014 for $800,000, and $7500 in deductible closing costs, would have a total cost of $807,500. If they sell their home in 2017 for $1,485,000, paying 6% in real estate commissions and buyers closing costs, their net profit is $588,400. Under Section the IRS rule, they qualify for the $500,000 exclusion because they owned and occupied it as their primary residence for more than the required two years.
The remaining $88,400 in profit is subject to long-term capital gains tax. If this same scenario were applied to a single owner, the taxable portion of the profit would be $338,400. If you purchased your home when you were single and later added a new spouse to the title, you might still be eligible for the married exclusion if you both meet the use test.
In this example, if you owned the home for three years, married your significant other after the first year, you qualify for the full $500,000 if you both lived in the home for at least two of those years. But on the other hand, you only qualify for the single exclusion, $250,000, if you married two and a half years after buying the home, and then sold it six months later – right after your new spouse moved in.
You should always advise a CPA prior to making a decisions, they can tell you if there are other circumstances or situations that help you avoid paying capital gains tax. If the main reason you sold your home was due to a change in your workplace location, a health issue or another unforeseeable event, you might meet the requirements for the partial exemption.
And if your situation is complex for any reason, take the time to meet with a tax professional before you list your home for sale. Huntington Mortgage are not CPA’s or tax professionals, this is just an educational blog to help understand Capital Gains.