Can You Avoid Capital Gains Tax When Selling a Home?

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We’re going to go out on a limb here and suggest that nobody likes paying taxes. Of course, you must pay your taxes, but that doesn’t mean you can’t look for a break here or there. If you’re selling your home this year, you may stand to make a nice profit, but the IRS is assuredly lurking. So, you ask, “How can I avoid capital gains tax on a home sale?”

It’s a common question for savvy homeowners. The IRS considers homes capital assets, making them subject to capital gains tax, which can be a real nuisance in this seller’s market. With home values appreciating across the country, many are looking to cash in on their biggest asset. Fortunately, thanks to the Taxpayer Relief Act of 1997, many can pocket the profit without paying capital gains tax.

In this piece, we’ll explain this important piece of legislation and discuss how you can legally avoid capital gains tax when selling a house. Because who wants to hand all their profit to the government?

What is a capital gains tax?

First, a capital gains tax is a tax assessed on the difference between what you pay for an asset (cost basis) and what you sell it for (sale price). Capital gains taxes most often apply to investments like stocks and bonds, but also apply to material assets like cars, boats and real estate.

What is the Taxpayer Relief Act of 1997?

The Taxpayer Relief Act of 1997 allows homeowners to write off up to $250,000 of capital gains (or $500,000 for married couples filing together) from their tax burden. Basically, it’s a major exemption from real estate capital gains tax on a single home.

But, in order to claim the exemption, you must meet one important criteria. Your home must be a primary residence, meaning you must have occupied it for at least two of the last five years. So if you bought a home last year, and your local market is on fire, selling it for a major profit is a bad idea. You’ll owe capital gains tax.

That said, those two years in residence don’t have to be consecutive. Married taxpayers filing jointly must each meet the two year in five rule individually.

So, when do you pay capital gains on a home sale? You will lose the $250,000/$500,000 exclusion if any of these factors are true:

  • The house wasn’t your primary residence.
  • You owned the property for less than two years before you sold it.
  • You didn’t live in the house for at least two of the previous five years before you sold it.
  • You already claimed the capital gains tax exclusion on another home in the two-year period before you sold this home.
  • You bought the house through a like-kind exchange in the past five years. (This means you swapped one investment property for another, also known as a 1031 exchange.)
  • You are subject to expatriate tax.
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How to avoid capital gains tax on home sales

We’ve covered the primary means of avoiding capital gains tax that just about every home seller can claim. (If you made more than $250,000 profit, well done.) But there are other ways to avoid or reduce capital gains tax.

Adjustments to the cost basis

The price you paid for your home is your cost basis. Making adjustments to this number can reduce your overall gain, ensuring that you fit inside the exclusion maximum or helping you lower what you owe in capital gains tax.

Since you don’t have to report your official cost basis until you’re filing, you can retroactively adjust your cost basis. Some of the best ways to do this is by including fees and expenses involved in the purchase of the home and the costs of home improvements or additions.

You can also use capital losses from other investments to offset the capital gains from your home sale. Obviously, you’d prefer it not to happen, but if you take a big loss in the stock market, you can carry those losses forward to subsequent tax years to help offset your overall capital gains tax burden.

Use 1031 exchanges

A 1031 exchange is named after IRS Code Section 1031, which allows for the exchange of like property with no other consideration or like property including other considerations, like cash. That means you can avoid paying taxes on the sale of your home by reinvesting the proceeds into a similar home, within 180 days, through a 1031 exchange.

According to the IRS, “Properties are of like-kind if they’re of the same nature or character, even if they differ in grade or quality.” So you won’t need to buy a house that, say, costs just as much as your previous home in order to qualify for this exchange. That said, your replacement property needs to be of equal or greater value for you to receive the full benefit of the exchange.

In this type of transaction, the capital gains tax is deferred, not eliminated, so you may eventually owe if you don’t use a 1031 exchange on your next home. It’s a complex process, so it’s a good idea to work with a 1031 exchange company if you plan to go this route.

Convert your second home into your primary residence

We touched on this method of claiming the capital gains tax exclusion earlier, but how do you actually do it?

To recap: 

  • Homeowners who can prove a second home was their primary residence for a total of 730 days over the previous five years can claim the tax exclusion. 
  • However, you can only apply the capital gains exclusion to the term that you used the property as a primary residence. 
  • So, if you only lived in a residence for three of the last five years, you may only exclude capital gains earned in those three years. 

How do you know your capital gains in specific years? A tax professional can help you earmark these gains so you don’t claim the entire profit on your sale of a property and risk audit.

This is a confusing stipulation, we know, and one that is unique to every situation — so make sure to consult a tax expert before trying to claim the complete exclusion.

Shielding the sale of a second home from the full capital gains tax is difficult. According to the IRS, the home would have to be an investment property exchanged for another investment property. You must have owned the first property for a minimum of two years and rented to someone for a fair rental rate for at least 14 days in each of the previous two years. It cannot have been used by you for 14 days or 10% of the time it was otherwise rented — whichever is greater for the previous 12 months.

Basically, this is a long-winded way of saying it’s really hard to avoid paying at least some capital gains tax on an investment property. If it’s a vacation home, you will have to pay capital gains taxes on the sale. Again, a tax expert can help you navigate this complex path.

Nobody wants to pay taxes that they don’t have to. When you make a windfall profit by selling your home, it’s just fiscally smart to mitigate your tax burden. While there are laws in place to help you avoid paying capital gains tax when selling a home, you may start to run into challenges when selling vacation homes or investment properties. There are still ways to lessen your tax burden, however, if you’re ready to get into some complex tax law.

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