Homeowners might consider selling their homes for many reasons, such as relocating to a better area or downsizing once children have moved out. In addition to the emotional and practical considerations, it’s essential to factor in the potential cost of selling, especially if the value of your primary residence has significantly appreciated. In such cases, a sale of a primary residence may trigger capital gains taxes. We’ll explain how to estimate capital gains and explore strategies homeowners may consider to help minimize their tax liability.
How are Capital Gains Taxes Calculated on a Primary Residence Sale?
You can estimate capital gains on a primary residence sale by subtracting the home’s adjusted basis (which includes the original purchase price plus the value of any qualifying home improvements) from the sales price:
Formula:
Adjusted Basis = Original Purchase Price (Basis) + Home Improvements
Potential Capital Gains = Sales Price − Adjusted Basis
For example:
- Original Purchase Price (Basis): $100,000
- Home Improvements: $300,000
- Adjusted Basis: $400,000
- Sales Price: $1,000,000
- Capital Gains: $600,000 ($1,000,000 − $400,000)
Important Considerations:
- This simple example does not include selling costs, such as closing costs and commissions.
- The proceeds from a sale are different from the capital gain.
- A primary residence mortgage that’s been paid off does not offset capital gains and is not part of the calculation.
What Are the Capital Gains Tax Rates?
Your capital gains tax rate depends on your income, location-specific factors such as state and local taxes (e.g., California), and variables like the Net Investment Income Tax (NIIT).
- The federal tax rate for capital gains increases from 15 to 20% for singles earning $518,900 or more, and couples earning $583,750 or more. Your adjusted gross income (AGI), including taxable gain, may push you into a higher tax bracket.
- In California, the state tax rate adds another layer, with a base rate of 9.3% and a top rate of 13.3% on top of the federal tax. Curious about the states with no income tax? Read our blog post here.
- The NIIT rate is 3.8% on net investment income if your modified AGI exceeds $200,000 for singles and $250,000 for married couples filing a joint return. This is a different threshold than the capital gain income threshold for moving from a tax rate of 15 to 20%.
The gain in our example is considered “unearned income,” meaning not from a business or employment, and it would be included in AGI on your tax return. Various factors affect the total tax amount, which is why talking with a CPA or tax professional is crucial.
Is There a Capital Gains Tax on the Sale of My Primary Residence?
Per the Taxpayer Relief Act of 1997, married couples filing a joint return may exclude a gain of up to $500,000 from taxation for the sale of a primary residence. For singles, the exclusion is $250,000.
To qualify for the capital gain exclusion, homeowners must have lived in the home as their primary residence for two out of the last five years. Under current tax regulations, homeowners can utilize the exclusion repeatedly, provided the residence meets the two-year occupancy requirement.
Common Questions About Reinvesting Capital Gains
Can I Reinvest Capital Gains on a Primary Residence?
Yes, you can. Sellers of primary residences are free to keep their sales proceeds without purchasing another primary residence.
Is There a Deadline to Reinvest Capital Gains If I Purchase Another Primary Residence?
No, under the 1997 rules, there is no deadline for reinvesting capital gains realized on the sale of a primary residence.
How Can I Avoid Capital Gains on the Sale of My Primary Residence?
Inheritance is one of the primary ways a homeowner can avoid paying capital gains on the sale of a primary residence. When inherited, heirs benefit from a “step up” in basis, which adjusts to the home’s current market value at the time of the original owner’s death. For example, if the homeowner purchased a house for $500,000 and the fair market value at the time of their death is $1.5 million, the heir’s basis on the property would be $1.5 million. This could significantly reduce the capital gain liability for the heir if they choose to sell. Additionally, if the heir decides to sell the home immediately, there would be no requirement to occupy it for two years and no capital gain tax would be due.
How Can I Offset Capital Gains on the Sale of a Primary Residence?
There are strategies to offset or reduce capital gains on the sale of a primary residence. We encourage you to discuss your options with your financial advisor and a tax professional. Here are a few things to consider:
- Home Improvements: Qualified home improvement costs can be added to your home’s basis (original price), reducing potential capital gains. Documenting home improvement costs is essential, especially over many years. We recommend saving all your home improvement receipts for as long as you’ve lived there to ensure accurate documentation and identify potential deductions. However, things such as painting or repairing a broken window pane are deemed maintenance. Consult with your tax professional for expenses that qualify for addition to basis.
- Gifting: If you gift your home to an adult child, the gift transfers at your original basis. Let’s say the basis is $100,000, and the property is valued at $1,000,000 at the time of gifting. If the child decides to sell the home, the child may need to live in the house for two out of the last five years to qualify for the $250,000 capital gain exclusion. In this example, if the child meets the requirement, the taxable gain would be $650,000, and the seller of the gifted property would pay the capital gain tax.
- 1031 Capital Gain Deferral: For investment properties, a 1031 exchange allows you to defer capital gains by reinvesting the sale proceeds into a new property. The exchange has various requirements and deadlines to consider, especially if you are using the property for rental. Please consult your advisor or tax professional to learn more. There are more tax-deferral strategies you can consider for investment properties, including using your IRA to purchase real estate. Learn more about the pros and cons of this approach in our blog.
Evaluating Capital Gains Taxes on a Primary Residence Sale
At Opes Wealth, we specialize in integrating real estate analysis into comprehensive financial planning to consider tax implications and identify opportunities when managing our clients’ wealth. Learn more about our real estate analysis process here. We’re available to address your home sale questions, guide you through estimating potential taxable gains, and assist with acquiring a new home. Our expertise extends to assisting clients facing a variety of situations, including those who:
- Have significant assets tied up in a home
- Are seeking guidance about real estate decisions as retirement approaches
- Want to integrate the impact of a high cost of living area on their overall financial planning
We help clients every day with overall financial strategies. However, we can not give tax advice. We strongly recommend working with a tax professional to guide you through the complexities of taxation. A tax expert can help determine if there will be a taxable gain, how much you may owe, and how much sales proceeds you keep. We work closely with our clients’ tax professionals to maximize opportunities.
We understand navigating taxes can be overwhelming but we’re here to help you thoroughly prepare so you can focus on what you’ll gain from your next real estate move, such as financial breathing room, exploring a new lifestyle, or the peace of mind of finding your forever home. Please get in touch with our team to learn how we can assist you during this exciting transition. In the meantime, read more about our Real Estate Analysis services, or get started with our wealth assessment to get a baseline of your current financial situation.
Written by: Ann Timoney Personal Financial Advisor, CFP®
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