One of the most frequently asked questions and something that is commonly misunderstood about selling your home is what taxes you will pay. The tax code can be confusing and isn’t always black and white. Hopefully the takeaway from this article is you likely won’t pay any taxes and if you do, they may be less than you expect. If you are holding off selling due to taxes contact me and I can point you in the right direction of how to find out what you will pay based on your situation. In addition, looking at IRS Publication 523, Selling Your Home is a great resource to understand what taxes you may or may not have to pay.
2 In 5 Exemption
If you have lived in your home for 2 of the previous 5 years than you should qualify for the “2 in 5 Capital Gains Exclusion.” This will allow you not to pay capital gains taxes on $250,000 per individual or $500,000 per couple.
Many people who call me think that means if they are a couple and their home sells for $600,000, they will pay taxes on $100,000. That isn’t the way it works. To arrive at your gain, you will take the sales price of your home minus closing costs and subtract from that your basis which the original purchase price. You may also be able to add any capital improvements to your basis.
For now, let’s keep the math simple. If you are a couple and you bought your home for $400,000 and sell it for $800,000 you have a $400,000 gain. If you qualify for the 2 in 5 exemption you would not have to pay capital gains taxes on the $400,000.
If you are a couple and bought your home for $400,000 and sold it for $1 Million you have a $600,000 gain. You would be exempt from $500,000 and then pay capital gains taxes on the extra $100,000. You would not pay taxes on the entire $1 Million. This is a good problem if you are the type of person who looks at the glass as half full!
You can only use the “2 in 5 Exclusion once every 2 years.
Do You Need To Buy Another House To Avoid Taxes?
No, you do not need to buy another home or use the profit you made towards a down payment on your next home to qualify for the “2 in 5 Exemption.” Later I will talk about selling an investment property which is more complicated.
What Are Capital Gains Taxes?
If you don’t qualify for the “2 in 5 Exemption” you may have to pay a capital gains tax.
If you owned the home less than 1 year it would be a short-term capital gain taxed at your ordinary income tax rate.
If you owned the home longer than 1 year you would pay based on the long-term capital gains tax rate schedule which could be between 0% and 20%. There are many online calculators that will help determine what you will pay, if any, based on your situation.
Remember to calculate your gain correctly and not use your sales price because that will give you too high of a tax to pay.
If the home you are selling is an investment property you will also have to pay the depreciation recapture tax and depending on your income you may pay the 3.8% Net Investment Income Tax. You should consult with whoever is doing your taxes to discuss those taxes based on your situation.
What If You Are Relocating?
If you don’t qualify for the “2 in 5 Exclusion” you should still check to see if you can qualify for a “Partial Exclusion of Gain.”
In IRS Publication 523 they talk about the different scenarios that would mitigate the amount of taxes you would pay. For example, if you are relocating or needing to sell for health-related reasons you may be able to qualify for a partial exclusion.
Investment Properties and 1031 Exchanges
If you are selling an investment property you may be able to defer the capital gains tax by buying another property and doing a 1031 Exchange. We have helped many investors navigate the 1031 Exchange process both selling a current investment property and buying the replacement property. Contact us to talk about how a 1031 Exchange may help with your situation.
When it comes to the tax code unfortunately the correct answer is often “it depends” based on your income and situation. As always, reach out to your tax and financial advisors to find out exactly what taxes, if any, you will have to pay when selling your home.
If your plans for 2022 include buying or selling real estate in the Austin area call or text us at 512-791-7473 and we can assist you to help make it happen this year.