Do You Pay Taxes When You Sell Your Home?

Welcome to The Clark Group Planning Minute, where we discuss topics (1-2 minute read) on retirement and investment planning strategies.

We often get asked by clients about the appreciation in their home, also known as capital gains, and whether that gets taxed once sold. Under the tax code, there is an IRS rule known as the Section 121 Exclusion, whereby when you sell your primary residence, you can exclude up to $250,000 or $500,000 of capital gains from being taxed. If you file your taxes as a single taxpayer, it is $250,000 and if you file jointly with your spouse, it is $500,000. In order for taxpayers to get this capital gain exclusion, they must have lived in the home for 2 out of the past 5 years. However, those years do not need to be consecutive, they just need to accumulate to a total of 24 months within the past 5 years. There are a few exceptions to this 2-year rule, such as relocating due to health, work, or divorce.

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With this IRS rule, understanding your cost basis is crucial to determining how much, if any, you may owe Uncle Sam once your sell your property. Your cost basis is known as what you paid for the property, or the original value of your property when you purchased it. In addition, any capital improvements made over the years, as well as closing costs when you purchased the property, can be added to your cost basis.

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Let’s use an example where you and your spouse purchased a home for $1,000,000. You have closing costs of $20,000 and over the course of a few years, you made capital improvements such as a new roof, which totals $80,000. Your cost basis is now $1.1mm. After 8 years of living in the home, the value is at $1.5mm and you sell it at that price. If you lived in the home for 2 out of the past 5 years, or rather a total of 24 months in the past 5 years, you could sell that property without having to pay any taxes on the appreciation. That is fantastic news for those looking to sell their home and either upsize or downsize, and they have stayed within that exclusion amount. Now, let’s use the same example, but say that the appreciation went above the $500,000 exclusion amount. Well, the homeowner would then have to pay long-term capital gains tax of up to 20% on the federal level, and in states like California, there are also California capital gains taxes (which is just state income tax).

One final strategy I am going to discuss is a 1031 exchange, which can help taxpayers avoid capital gains taxes entirely on the sale of real estate. There are times where people will turn their primary residence into a rental property, rent it out for a couple of years, and then try to sell that rental property. Well, as long as your rental property was your primary residence for 2 out of the past 5 years before you sold it, you can still utilize the capital gains exclusion amount.

Let’s use an example where you rented out your old primary residence and it is now a rental property, but you don’t qualify for the 2 out of 5-year rule because you rented out your property longer than that 5-year period. Well, there is still a way to avoid paying capital gains taxes once you sell that real estate, which is by utilizing a 1031 exchange. With this strategy, you can sell your property that is used for business or investment purposes, so in this case a rental property, and purchase a new rental property that is considered “like-kind” within a certain amount of time. By doing this, you can avoid capital gains taxes on this type of transaction, and hypothetically, you can continue doing the 1031 exchange over and over in future years. Lastly, if you continue to do this until you pass away and become an angel, your beneficiaries will get a step-up in cost basis to the fair market value on the date of death. That means that if the beneficiaries sold the home right away, they would not have to pay any capital gains taxes. There are estate tax exemption amounts, which we won't get into in this article, but most people fall below that exemption amount.

As always, speak to your fiduciary financial advisor or tax advisor before implementing anything we discuss in these articles. Hopefully this helps with financial planning around your real estate assets!

This is not intended to be legal or tax advice. Please consult your tax advisor before implementing anything discussed in this article.

For important disclosures, please visit: clarkgroupam.com/disclosure.