For example, if you are single, have taxable income of $50,000, and have a $25,000 long-term capital gain, it will be taxed at a 15% rate.
In addition, there's a 3.8% net investment income tax that applies to certain high-income households, regardless of whether gains are short- or long-term in nature.
How much will your capital gain be?
If you paid $100,000 for your home 20 years ago and sell it for $300,000, you have a $200,000 capital gain, right? Well, not exactly.
One important point to know is that capital gains aren't simply based on the difference between the price you paid and the sale price. It is the difference between your cost basis and your net proceeds. This complicates matters a bit -- but in a good way. So, let's take a look at both of these concepts.
Know your cost basis
Think of cost basis as your "all-in" cost of acquiring an asset, not just the purchase price. In real estate, there are two big considerations here:
Did you pay transfer taxes, legal fees, survey fees, or any other costs related to the purchase of your home? These add to your cost basis. Keep in mind that any mortgage-related expenses like origination charges don't count, nor do prepaid insurance or property taxes.
If you spent money on improving your home, you can add these expenses to your cost basis as well. They must be value-adding improvements, not just standard maintenance or repair costs. If you spent $30,000 renovating your kitchen, for example, that would be included in your cost basis. Other common capital improvements that you can include in your cost basis are additions, major landscaping projects, a new roof, siding, floor replacements, and HVAC replacements.
How much did you really make when you sold your home?
Your net sales proceeds refer to the amount of money you sell your home for, minus any transaction-related costs, such as real estate commissions. With the industry standard selling commission about 6% of the sale price (3% each to the buyer's agent and listing agent), this can make a big difference when calculating your capital gain.
Other things that reduce your net selling price can include any legal fees you pay, as well as any costs of advertising your home for sale.
Putting it all together
Let's say that you bought your house for $100,000 many years ago and paid $2,000 in other transaction-related costs. About 10 years ago, you spent $30,000 to renovate your kitchen, and five years ago, you spent $25,000 to build an addition. Adding these up gives you a cost basis of $157,000.
Now, let's say that you agree to sell your house for $300,000. You pay real estate commissions and other selling-related expenses of $20,000. This gives you a net sale price of $280,000. Subtracting your cost basis shows a capital gain of $123,000 -- certainly a lot of money, but much less than the $200,000 difference between the purchase price and sale price.
Note that calculating your cost basis and net selling price can be quite complex, and the IRS tends to take a closer look at returns with home sale-related capital gains, so it's a good idea to seek guidance from an experienced tax professional when the time comes.
The home sale gain exclusion: How it works
Now that you know how to figure out your capital gain, the next step is to figure out whether any of it is taxable.
There are very few capital gains tax exclusions, but the IRS does have one such loophole for some home sellers -- specifically, those who sell their primary residence. This is known as the home sale gain exclusion and allows as much as $250,000 in capital gains to be excluded from taxation for single individuals, or as much as $500,000 for married couples who file joint tax returns.
In order to be able to use the exclusion, you must:
- Own the home for at least two of the five years preceding the sale.
- Use the home as your primary residence for two of the five years preceding the sale.
- Not have used the exclusion for another home sale within two years preceding the sale.
This means that if you're married and sell your home for a net profit of $500,000, as long as you meet the qualifications outlined above, the IRS can't touch a penny.
An example of calculating capital gains tax (or lack thereof)
Let's look at an example of how this might work from start to finish.
Here's the scenario. You're a married couple who expects $120,000 in taxable income for 2020. You bought your house five years ago for $500,000 and paid $10,000 in closing expenses. You also spent $25,000 to renovate your master bathroom shortly after the sale. Since purchasing the home five years ago, you've lived in it year-round as your primary residence.
During those five years, your real estate market has exploded in value. You accept an offer to sell your house for $1,200,000. You pay $50,000 in real estate commissions and other transaction costs necessary to complete the sale.
You sold your home for net proceeds of $1,150,000, and you had a cost basis of $535,000, giving you a long-term capital gain of $615,000. However, since the home met the qualifications for the home sale gain exclusion, $500,000 of your gain is exempt from capital gains taxes -- only $115,000 of the sale proceeds will be taxable.
Referring to the capital gains tax brackets chart earlier, we see that a married couple with $120,000 in taxable income would be in the 15% bracket. Applying a 15% capital gains tax rate to the $115,000 of taxable gains gives a capital gains tax of $17,250.
When is capital gains tax on a home sale due?
If you end up owing capital gains tax on a home sale, it is due with the tax return that coincides with the calendar year of the home sale. In other words, if you sold your home on February 1, 2020, you'd owe any capital gains tax by the 2020 tax return due date of April 15, 2021.
The Millionacres bottom line
After reading through this, you can probably guess that the majority of people who sell their primary homes don't end up paying any capital gains tax unless they sell their home at a big profit. By understanding how capital gains taxes work and why home sellers can be exempt from their gains, you'll know what to expect when you sell your home.