Key takeout
If you sell your house and buy another item, you will not automatically bear capital gains tax. Exclusion of major housing is the most common way to avoid paying capital gains tax. Investment properties follow a variety of rules and may require a 1031 replacement to postpone taxes. Maintaining records of purchase prices, improvements, and sales costs is important to reduce taxable profits.
Selling a home often comes with excitement, but it also raises questions about the capital gains tax. The general question homeowners have is whether they have to pay capital gains if they sell their home and buy another one. The answer depends on several factors, including whether the property is your primary residence, how much profit you made, and whether it meets certain IRS requirements.
This Redfin Real Estate Guide explains what the capital gains tax is, what you may or may not owe them, and strategies to minimize tax bills. Whether you sell your first home in Birmingham, Alabama and move to investment property in Miami, Florida, or not, understanding these rules will help you make smart financial decisions.
What is a capital gains tax?
Capital gains are profits that you make when selling assets, such as stocks, bonds, or real estate, for more than you originally paid. The IRS places these benefits taxes as capital gains taxes. Regarding real estate:
Short-term capital gains apply if you own the property for less than a year and are taxed at the regular income tax rate. Long-term capital gains apply if you own the property for more than a year, and the tax rate ranges from 0% to 20%, depending on your income bracket.
The good news is that if you are selling a major residence, you are eligible for a substantial tax exclusion under Section 121 of the Tax Act. This will even dramatically reduce or eliminate the tax impact of sales.
If there is a high possibility that you will not pay capital gains tax (Excluded by Section 121)
Under Section 121 of the Internal Revenue Code, homeowners can rule out a significant portion of their profit when selling their primary residence if they meet certain ownership and usage requirements. Submitting taxes as one individual will exclude profits of up to $250,000 from taxation. If you are married and submit jointly, you can exclude up to $500,000.
To qualify for this exclusion, both the ownership and usage tests must be met. The ownership test requires you to own the property for at least two of the five years leading up to sale, while the use test requires you to have lived in the home for at least two of those five years. This exclusion can only be argued once every two years. This means timing sales issues.
Types of houses eligible for exclusion
Exclusions do not apply only to traditional homes. I’ll cover that too:
Condo Mobile Home Trailer Houseboat
Example: If you are a single filer selling your home with a profit of $200,000 and meet both ownership and testing, you will not bear capital gains tax.
If you need to pay capital gains tax
The exclusion of Section 121 is generous, but there are scenarios where you can borrow taxes.
Investments or second residential exclusions apply only to major housing. The sale of rental property, vacation homes, or second homes generally means owing capital gains tax. If your profit exceeds $250,000 (single) or $500,000 (co-married submissions), you must pay taxes on the amounts above the threshold, exceeding the exclusion. If you fail ownership or use tests, it is important to consider living in your home for two years before selling. If you have not lived in the property for at least two of the past five years, you will not be eligible for exclusion. A rental property selling a major residence selling a rental property to sell a rental property may release cash to pay off your main mortgage, but the sale itself can cause a capital gains tax.
How about replacing the 1031?
Many homeowners hear about the idea of ”rolling” capital gains to another property and assume that applies to them. In reality, this refers to the exchange of 1031. This allows investors to defer capital gains tax by reinvesting revenues from one property into another “like” property. However, this applies only to investments or rental properties and is not a major residence.
For example, if you own a rental home and want to sell it and buy another rental, you can use a properly executed 1031 Exchange to defer taxes. However, if you are selling a private home to buy another home, this rule does not apply.
How to calculate gain
You must calculate your net profit before determining whether you are borrowing capital gains tax. Here is a step-by-step breakdown:
Start with the selling price for your home. Subtract your base including the total of major home improvements (renovations, additions, energy-efficient upgrades) at the original purchase price. Subtract sales costs like this:
The final number is the taxable capital gains. However, for long-term homeowners, another important consideration includes how to adjust the cost base if you defer profits under the old rollover rules. Before 1997, homeowners were able to use IRS Form 2119, a sale of your home, to defer the capital gains tax by applying profits from one home sale to the purchase of another home. If you have used this form in the past, the deferred gain will be deducted from the base of your new home, reducing your overall cost base.
If you sell the property today, the deferred profit must be taken into consideration. This could potentially increase your taxable profits. For example, if you put more than $40,000 in profits into a new home decades ago, the cost base will be effectively reduced by that amount. This means that your current taxable profits will be greater. This adjustment is important to homeowners who owned their property long before the rules changed, and they need to correctly calculate what they owe.
Other ways to minimize capital gains tax
There are additional strategies to reduce tax bills even if they don’t qualify for a complete exclusion.
Meet 2 years of ownership and use tests before selling. Exception: The IRS allows partial exclusions in the following cases: Health-related movements in employment transfers are unexpected movements Government workers: Certain federal employees and military personnel may qualify for long-term residence exceptions. Amortize home improvements: Maintain a record of capital improvements. These are to increase the cost base of your home and reduce taxable profits.
Frequently Asked Questions about Capital Gain Tax
1. Can I avoid capital gains if I buy another house?
no. In 1997, the old rollover rules (which allowed profits to be reinvested into another home) ended. Today, you must fulfill your ownership and use the test of your primary residence to qualify for exclusion.
2. What are the rules for 2-year and 5-year?
You must have owned and lived in your home for at least two years for the five years leading up to sales.
3. When you sell a house and buy a new home, do you pay capital gains tax?
It’s not automatic. If you qualify for the exclusion of Section 121, you may not borrow anything. But if it’s an investment property or your profits exceed the limit, you’re probably owing taxes.
4. How much do you have when selling a house to avoid capital gains?
There is no bounty period to “avoid” capital gains by buying another house. Instead, you must meet the IRS rules for exclusion.
5. What happens if you don’t sell your house and buy another house?
You do not need to buy another home to qualify for exclusion. Even if you meet the residency test, you can avoid taxes.
6. Are there any one-time capital gain exemptions?
Previously, there was a one-time exemption for homeowners over the age of 55, but has been replaced by the current Section 121 exemption.
