Selling your primary residence can be a stressful process, and many people often wonder how it will impact their taxes. Despite the relatively straightforward tax rules for home sales, there’s still a significant amount of confusion surrounding what homeowners will owe when they sell.
This confusion is partly due to how rare home sales are for most people, and also because the vast majority of home sales don’t actually result in owing taxes. However, it’s important to understand the tax rules that apply to ensure you’re prepared. Here’s a breakdown of what you need to know.
Can You Sell Your Home Tax-Free?
While selling real estate is generally considered a taxable event, homeowners who sell their primary residence may be eligible for a significant tax exclusion.
Thanks to the 1997 Taxpayer Relief Act signed into law by President Bill Clinton, homeowners can exclude up to $250,000 ($500,000 for married couples filing jointly) of capital gains from the sale of their primary home—provided they meet certain criteria.
This exclusion means that many homeowners will not owe any taxes when selling their home, especially since the median home price in the U.S. is well below the $500,000 threshold for married couples.
If your gains exceed the $250,000 or $500,000 limit, you’ll only be taxed on the portion above that amount. In higher-cost areas, where homes may be priced above $500,000, this tax break can save married couples anywhere from $75,000 to $111,000 in federal taxes, not to mention any potential state tax savings.
It’s also worth noting that losses from selling a primary residence are not deductible, so if you sell for less than what you paid, there’s no tax relief. Additionally, the proceeds from the sale do not need to be reinvested in another home to qualify for the exclusion—this is a common misconception.
Who Can Benefit from the Primary Residence Tax Exclusion?
To qualify for this tax break, there’s one key requirement: you must have lived in the home as your primary residence for at least two of the last five years. This requirement is fairly easy to meet, and you can take advantage of the exclusion once every two years, potentially saving you millions in taxes over your lifetime.
The Two-Out-of-Five-Year Rule: What Homeowners Should Know
If you plan on selling your home before reaching the two-year mark of residency, there is still a possibility you could qualify for a prorated tax exclusion.
This could apply if you sell early due to an unforeseen circumstance, such as job relocation, health issues, or other qualifying situations beyond your control.
In this case, the tax exclusion would be adjusted based on the time you lived in the home. For example, if you lived in your home for just one year before selling and experienced a $125,000 gain after real estate fees and closing costs, you could receive half of the standard $250,000 exclusion available to single homeowners, meaning no capital gains taxes would be owed. For married couples, these figures could be doubled.
How to Calculate the Real Cost Basis of Your Home
One common mistake homeowners make when calculating capital gains is assuming that the cost basis of their home is simply what they paid for it.
However, the cost basis is more complicated and includes not just the purchase price, but also additional investments you’ve made into the property during your ownership. This can include costs for major renovations, adding square footage, installing a new roof, or constructing additional dwelling units (ADUs).
To determine the capital gains tax on the sale, you’ll subtract the home’s cost basis (including these improvements) from the sale price (minus real estate fees and closing costs). Working with a tax professional is essential to ensure you account for every eligible expense that could increase your cost basis, which will lower your taxable gain.
Final Thoughts
Navigating the tax implications of selling your home doesn’t have to be complicated, especially when you know the rules. The key is to meet the residency requirements and keep track of any qualifying improvements you’ve made to your home.
Even if you’re not selling right away, it’s a good idea to track home improvement expenses, as they can help increase your home’s cost basis and reduce potential capital gains taxes when you do decide to sell. Working with a tax advisor can also ensure that you’re making the most of the tax benefits available to you.
