Understanding the scope of taxes on selling a house will help you get every deduction you deserve—saving up to $500K
According to the IRS, you can expect to pay taxes on selling a house when you’ve made capital gains. That refers to the net profit you’d gain from selling your house. However, if you make less than a net profit of $250,000 as an individual, you’d not be required to pay any tax.
Also, if you are married, and file returns jointly, each of you can file for a similar deduction, allowing you to save up $500,000 in home sale taxes.
However, there are a few caveats if you are to qualify for the $250,000/$500,000 profit tax-free.
- You must pass the Ownership Test
The IRS Publication 523: Selling Your Home states a homeowner can only pass the test if they have owned the home in question for at least two years, or a period accumulating to two years (730 days or 24 months) out of the five years leading up to the sale of the house.
That means you do not have to have lived in the home for two years back-to-back to qualify. Just ensure the total time you have lived in it adds up to two years.
- You must pass the Use Test
This test is all about establishing you have lived in the residence for at least two out of five years leading up to the sale.
To certify that, the home up for sale must have been your primary residence over that period. The IRS defines a primary residence simply as the house you live in most of the time.
If you own two homes say, a city house and a beach home and live in the city for the largest part of the year, only staying at the beach home in the summer, selling the holiday home (the secondary home) would attract the home sale tax.
However, if you have rented out the home but still lived in it or owned it for at least two years out of the five leading up to the sale, you still qualify for the tax exemption.
- You can only receive the deduction once every two years.
If you sell two homes within a two-year period, even if you pass the Ownership and Use tests, you will not qualify for another deduction until a period of two years elapses since the last sale.
So, how exactly do you calculate taxes on selling a house if your house capital gains are taxable?
Suppose you bought your main house for $150,000 a decade ago and pass the three requirements above. You then sold the home for $500,000 in 2018. How much tax are you obligated to report and pay up to the IRS?
It is not ($450,000-$150,000) $300,000.
The $300,000 is not your net profit, is it?
To get the net capital gains, you have to deduct capital improvements you made to the house over the years from the gross profit ($300,000) before calculating how much tax you owe from selling your home.
According to the IRS, not all home improvements count. Those that add value such as remodeling the kitchen, changing the roof, and adding a patio do count. But regular repairs and minor works such as plumbing repairs and paint jobs do not.
Other closing costs include advertising/listing and real estate agent. You’ll want to deduct those from the gross profit as well. If the remainder is less than $250,000 (or $500,000 for married couples), not only are you not required to pay any sale of home taxes, you do not have to report the transaction in your annual returns either.
What if you do not meet these qualifications?
“Unforeseen circumstances” can allow you to qualify for the exemptions despite not having lived in the primary residence for more than two years out of the five leading up to the sale day.
Such circumstances include having to move because your doctor says your health needs it, had multiple births, got divorced, moved to a nursing home, are on government assignment (uniformed forces, for example), and such.
If you do not meet any of the qualifying factors according to IRS Publication 523, though:
- And you have only lived in the main home for less than a year, you may pay taxes on selling a house—up to 23.8% of your sale of home profit, although it will depend on how the rest of your tax return looks
- Or have lived in it for more than a year, the capital gains tax rate will apply. Any capital gains above the excludable amount, if you have any, will be almost the same as the ordinary income tax rate.
Clearly, to grasp the taxes on selling a house that will affect you, you’ll want to consider the deductions you qualify for. If you pass both the Ownership and Use tests and have not received a deduction out of another home sale in the past 24 months, you can save up to $500,000 if you are a married couple and $250,000 for single homeowners. Be sure to keep all transaction records and home improvement receipts to help verify your claims.