DISCLAIMER: Information in this blog post is meant to be used for educational purposes only, not legal or tax advice. If you need help determining the taxes on your home sale, please consult a skilled tax professional.
Working. Shopping. Eating out. Getting gas. You pay taxes on so many things, it makes sense to want a break on paying taxes when selling your biggest asset: your home.
You’ve come to the right place if you’re wondering how to avoid paying taxes when selling a house. We’ve talked to a top real estate agent and a tax professional to help you understand the required home sale taxes and gathered the top ways to mitigate or eliminate the tax burden on your home sale.
Capital gains in real estate, explained
If you sell your house for more than you bought it for, you’re making a profit. The government considers that profit taxable in the form of capital gains. Just be aware that capital gains tax is calculated based on the gross profit, not the net.
Experienced CPA Robin F. Sansone, partner at Georgia-based Rhodes, Young, Black & Duncan, explains:
“If you sell your home for $200,000 and $50,000 of that sales price is used to pay off the existing mortgage and another $20,000 is used for closing costs, you may only receive cash of $130,000 at closing. However, you calculate your gain based upon the $200,000 sales price, NOT the cash received of $130,000.”
How the IRS decides to tax the capital gains from your home sale is based on whether or not your capital gains are long term or short term. This separates the average homeowner (who’s selling a house for reasons like upgrading, downsizing, or relocating) from the investor (who is buying and selling a number of homes annually for a profit — which qualifies the home sale proceeds as ordinary income).
Long term capital gains tax rates are typically 15% for the average individual, but can be as low as 0% or as high as 20%, depending on your income. These long term rates are generally lower than the standard income tax rates. And of course, only the gain (the amount you sold your house for above the amount you bought your house for) is taxed.
Short term capital gains are taxed as ordinary income, so the rate varies based on your annual income.
The opportunities available for lowering or avoiding taxes on your home sale depend on whether or not you’re a homeowner selling a primary residence (plus factors like how long you’ve lived there) or an investor selling an investment property.
How to avoid taxes on your primary residence
Fortunately, most home sellers won’t be taxed on every single dollar of profit made from their home sale. That’s because most primary residence sellers meet the guidelines to qualify for the capital gains tax exemption.
Thanks to the Taxpayer Relief Act of 1997, most home sellers qualify for the Section 121 exclusion that exempts home sale profits from capital gains taxes. Wenatchee, Washington-based real estate agent Perrin Cornell explains:
“When selling a residence, a single homeowner gets a $250,000 capital gains tax exemption and a couple gets a $500,000 exemption. For example, if a single person with a $100,000 mortgage sells a home worth $300,000, they have a capital gain of $200,000. With that $250,000 exemption, they’ll have no taxable gain at all.”
This exemption isn’t automatic, though. You’ll have to qualify based on two tests — ownership and use. According to the IRS, you must:
1. Own the home and live in it as your primary residence for at least two non-consecutive years out of the five-year period prior to the date of sale.
CPA Sansone recalls a client who qualified for this exemption even though the home she was selling was no longer her primary residence:
“I had a client who is single and living in Georgia. While her kids were in college in Georgia, she moved to a home in Florida, but kept the Georgia home for her kids to live in while in school. After two years, she decided to sell the Georgia home. Even though she no longer lived in the home, she had lived there for at least two of the previous five years. Therefore, she was allowed to take the $250,000 exclusion on the sale.”
2. Wait at least two years before claiming the exemption between sales of a primary residence.
You can’t always get this exemption just because you are selling your primary residence. This exemption is only allowable once every two years. If you claimed it for another property the 24 months preceding your current sale, you won’t be able to do so on a second property to avoid capital gains.
And expect the IRS to be unforgiving about the two-year minimum: “[Another] client owned their property for one year, nine months and three weeks, so he couldn’t get the capital gains tax exemption,” recalls Cornell.
3. Reduce your capital gain by deducting the cost of capital improvements made to your home from the proceeds of the home sale.
In order for a home improvement to qualify as a capital improvement, it must meet these three qualifications:
- It substantially increases the value of the real property (e.g. installing new kitchen cabinets or building a deck), or appreciably prolongs the useful life of the real property (e.g. replacing the water heater or HVAC).
- It becomes part of the real property or is permanently affixed to the real property so that removal would cause material damage to the property or article itself.
- It is a permanent installation/improvement. (For example a temporary, above-ground pool, versus a permanent in-ground pool.)
CPA Sansone explains:
“As you make home improvements over the years, keep a record. We accountants love spreadsheets and that would be the easiest way to keep track of those improvements, like a new HVAC system, a new roof, new flooring, etc.
“These items are an integral part of the home that are usually not removed from the property when you sell. Please note that I do not mean that you keep track of every time you paint your home or clean the windows. These are normal expenses of home ownership.”
Basically, if you’re replacing any major item in the home and that increases your home’s value, that is a capital improvement. But if you’re repairing or improving the condition of existing elements in the home, it’s not a capital improvement.
So, items that won’t qualify as capital improvements include things like repainting, driveway sealing, appliance repairs, and so forth.
NOTE: There are two exceptions that make you ineligible for this capital gains tax exemption altogether, even if you meet other qualifications. You are ineligible for the capital gains tax exemption if:
- You acquired the property through a 1031 Exchange (more on these later).
- You’re subject to the expatriation tax (which applies if you renounce your citizenship and move out of the country).
How to avoid taxes on your investment property
Investors who cannot qualify for the capital gains tax exemption still have options to save on taxes when selling an investment property.
As these tax-avoiding arrangements are quite complex, you should enlist the help of a real estate attorney, or real estate savvy tax professional so that you don’t fall victim to all of the red tape.
Use the 1031 exchange
The 1031 exchange is one of the most common tools used by savvy investors to avoid the endless annual cycle of massive taxes on their real estate transactions.
“A 1031 exchange, commonly referred to as a ‘like-kind exchange,’ allows you to exchange one investment property for another without recognizing gain at the time of the exchange. However, you will want to work closely with your accountant to structure the exchange properly to avoid tax,” says CPA Sansone.
You don’t need to be a big time investing corporation to take advantage of a 1031 exchange; even individual investors can defer taxes through an exchange. But your investment properties will need to meet specific requirements. According to the IRS 1031 Fact Sheet:
- “Both properties must be held for use in a trade or business or for investment.” In other words, your primary residence, second home, or vacation home will not qualify for deferred taxes through a 1031, like-kind exchange.
- “Both properties must be similar enough to qualify as ‘like-kind.’ Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate.” Basically, this means that you cannot defer capital gains taxes on a property sale and then use your profits to invest in the stock market instead. You must purchase more real estate if you defer taxes in a like-kind exchange.
There are also several rules that you must follow when using a 1031 exchange:
- You must identify up to three properties to purchase through the exchange within 45 days after selling the original property.
- You must also close on a new property within 180 days from the closing date on the sale of the original property.
- You are advised to use a qualified intermediary (QI) when doing an exchange. The QI is a third-party company that holds onto the money for those 45 to 180 days while you arrange the purchase of a new property. You are not allowed to hold onto the money yourself when using a 1031 exchange.
It’s important that you don’t just hire any QI that you come across — you need a reputable one to take charge of all that money, even for this short period of time.
The IRS warns that some QIs have either declared bankruptcy or been otherwise unable to meet their financial obligations, leaving you and your money stuck in a legal and financial mess.
And don’t expect the rules of the 1031 exchange to bend because of your QI troubles. If you fail to meet the 45-day or 180-day requirements, you will be taxed immediately on the proceeds from your investment property sale.
Consider utilizing a charitable remainder trust
Another, lesser-known option to avoid paying taxes on an investment property sale is through a charitable remainder trust (CRT). This option is best suited for retirees who are willing to donate the house to their favorite charity, such as a church or university.
Essentially, a charitable remainder trust lets you donate an investment property to the charity of your choice by putting it into a CRT, which allows the charity to sell the property at a 0% tax rate.
But you’re not just giving the whole house away to the charity.
A CRT offers a lot of benefits, including saving on taxes. With a CRT you can:
- Avoid paying any capital gain taxes on your home sale.
- Generate an income stream for the duration of your life — and even your children’s lives with the proper structuring.
- Diversification of investment assets.
- Potentially avoid hefty estate taxes, (since it’s technically no longer a part of your estate).
- Donate a sizable gift to your favorite charitable organization.
A CRT puts the proceeds of the sale into a trust that invests the money and pays an income out to you for the remainder of your life. You can even write the terms of the trust to pay that investment income to your children after you pass away.
You will also receive a charitable income tax deduction that allows you to reduce your adjusted gross income by up to 30%. That puts even more cash into your wallet.
Agent Cornell explains how it works in more detail:
“Let’s say you want to donate the proceeds of your home sale to your alma mater or a hospital. You would have the house appraised, then transfer it into a taxable exempt trust. The university or hospital then sells the property and pays you a portion of its value annually as income, normally around 5% or up to 10% of its appraised value.
“So, you’ll get a tax deduction for the charitable contribution of let’s say the $200,000 value of the home, plus you’ll get $1,500 a month as income from the trust, which isn’t a bad deal.”
Once all beneficiaries of the trust have passed on, the remaining investment in the trust goes to the charity. So, you’re giving a gift to a charitable organization, and you’re getting a tax deduction on that gift that you can apply against your income taxes for both previous or future years.
Plus, you’ll get that income from the trust for life or for a certain number of years (depending on the terms of the CRT). The only one who really loses out in this arrangement is the IRS.
Make your fixer-upper your primary residence
House flippers usually buy a home, fix it up, and sell it within a 12 month span. But — then you’re going to be on the hook for capital gains. Instead, you could choose to sell or lease your current primary residence, and move into your investment property for at least two years. That gives you plenty of time to spread out the construction costs and repairs timeline.
It also sets you up to take advantage of the capital gains tax exemption on the house you’re flipping so that you won’t lose a large chunk of your profits to the IRS.
Taking a little (or a lot!) back from the IRS
No one minds paying taxes to help fund our country. But when the IRS wants to take a huge bite out of the proceeds (from the sale of a home purchased with income that you’ve already been taxed on), it can feel like overkill.
But with some savvy financial planning, tax expert assistance, and the help of a savvy real estate agent, you can sell your house without giving up too much money to Uncle Sam after all.
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