For many people, their home is their primary investment. Seeing your home appreciate in value over time means financial security. But that increase in value—known as “capital gains”—is subject to local, state, and federal taxation. The Internal Revenue Service (IRS) collects capital gains tax on the difference between the price you paid for the house (the “basis”) and the amount the house sells for. Depending on your income, that federal tax rate can range from 0% to 23.8% (the highest federal bracket is 20% plus a 3.8% tax on unearned income, which funds the Affordable Care Act).
Let’s say you purchased a home in Orange County in 1994 for $500,000. In 2016, you sell that home for $1,000,000. You’ve realized $500,000 in capital gains. Depending on your income, the IRS will be looking for up to $119,000 from you in capital gains tax.
Fortunately, the IRS tax code provides some exclusions if certain conditions are met, which can reduce or even eliminate any capital gains tax liability. While there are exceptions and specifications to these conditions, generally speaking, they are:
You owned the home for five years preceding the sale (the “ownership test”)
You used the home as your primary residence for at least two of the five years preceding the sale (the “use test”).
You have not used the exclusion on another home sale in the preceding two years
If you meet these three conditions, you may be able to exclude $250,000 of your capital gain if filing as single taxpayer or $500,000 of your capital gain if filing jointly.
If you’re a single taxpayer, you can exclude $250,000 from that $500,000 capital gain; based on these numbers, halving your capital gains tax liability. As a joint filer, you can exclude $500,000 from the $500,000 capital gain, resulting in a $0 capital gains tax.
If the exclusion doesn’t completely eliminate your tax liability, bear in mind that there are other factors affecting your gain. Your basis in the house should reflect all the improvements you’ve made to the property over the years. And the sale price is subject to certain deductible expenses.
Let’s say you’re the single filer above with $250,000 subject to capital gains tax and let’s re-examine your basis and sale price. If you spent $200,000 on home improvements over the time you owned the home, your basis is increased to $700,000 ($500,000 original purchase price + $200,000 in improvements). Let’s say you had $50,000 in costs at the sale (realtor commission, inspections, etc.) so the sale price used is $950,000 ($1,000,000 – $50,000). Now you’re working with $950,000 – $700,000, resulting in capital gains of $250,000. With the $250,000 exclusion applied ($250,000 – $250,000), you’ve realized $0 in capital gain.
In these examples, we’ve shown how your federal capital gains tax may be reduced or eliminated entirely. But your capital gains may also be subject to local and state taxes. State and local tax rates vary, with California coming in at the highest (33.8%). For more information on state tax rates, see http://taxfoundation.org/blog/how-high-are-capital-gains-tax-rates-your-state.
If your home has appreciated in value and it’s time to sell, protect your money from tax liability. Before you put your home on the market, consult with a real estate attorney, financial planner, or CPA to ensure you maximize your basis and allowable deductions to reduce your capital gains tax liability. Attorney Christopher Glenn Beckom works with homeowners to ensure they comply with and maximize any benefits provided by the capital gains provisions in the tax code. Call our offices at 800-581-7030 for exceptional legal guidance.