Selling a home is a big financial transaction. In most cases, hundreds of thousands of dollars move between banks, title companies, buyers, sellers and agents. After the dust settles, you can find yourself with a substantial tax bill.
However, in many cases, you won’t owe a cent.
Most home sales are tax-free
When Bill Clinton was president, Congress doubled down on homeownership. The federal government decided that homeownership is in the best interest of American families, and as part of the American Dream should not be taxed or penalized in most circumstances.
These benefits extend into today as the mortgage tax deduction and home sale capital gains tax exclusion. Today, most Americans still enjoy tax-free mortgage interest and home sales. However, there are some cases where you do have to pay a big chunk of your property sale to Uncle Sam.
Taxes on the sale of property
If you own and live in a home for two of the past five years, you can take advantage of a big tax deduction when you sell the property. Because of this rule, you generally can’t use this tax deduction more than once every two years and the deduction only applies to your primary residence.
There are some cases where you can live in the home for less than two years and still take the deduction, most notably if you move for your primary job. You can also qualify for a waiver on the two-year rule if you had to sell a home for health reasons or other “unforeseen circumstances” as outlined in IRS Publication 523.
If you qualify for the deduction, you can exclude up to $250,000 in profit from the sale of your home. That jumps to $500,000 for married couples filing jointly. Because of the high deduction limit, most home sales qualify for the deduction.
Homes with a profit that’s more than that amount are subject to capital gains taxes on the additional profit. For example, if you lived in a home with your spouse for the required amount of time and sell it for a $550,000 gain, you have to pay capital gains taxes on $50,000 of the $550,000 profit.
However, you can also take closing and other transaction costs into account when calculating the profit on a home sale. Just because the value increased by more than the taxable limit doesn’t mean you owe taxes. If you sell your home for a $550,000 increase in home price but paid $30,000 in closing costs, you would only pay capital gains tax on the $20,000 profit.
What about second homes and vacation properties?
Second homes, vacation homes and investment properties are not subject to the same tax exclusion that you get with your primary residence. The tax code was designed so wealthier individuals and families pay more taxes than poorer individuals and families. Because of this, you can’t exclude the taxes on your second home.
Because it was not a primary home under the rule of residency for two years of the past five years, all capital gains from the sale of a second home or vacation home are taxable. However, keep in mind that capital gains taxes are lower than your regular income taxes.
For short-term gains, if you owned the property for less than a year, you pay your regular income tax rate. For most people, that is 25 percent to 28 percent. For long-term gains, expect to pay 15 percent in most cases. Filers in the 10 percent and 15 percent tax brackets pay no capital gains taxes, while those earning more than $200,000 per year (single filers) or $250,000 per year (joint filers) pay 18.8 percent including the 3.8 percent Affordable Care Act capital gains tax.
When in doubt, talk to an expert
Just like a trusted real estate agent will stand by your side when buying or selling a home, you should contact a tax expert if you have any doubt about your taxes after selling a home.
Filing taxes incorrectly can lead to fines and penalties or an overpayment. Any of those are bad for your bank account, so it can be worthwhile to hire a CPA to help you file your taxes the year after a home sale.