How to Reduce the Capital Gains Tax on Home Sales

Why is this important right now?

Your wallet can attest to this: overall cost of living has significantly increased in the U.S. since 1997. But even after 27 years, the capital gains tax threshold does not account for inflation. Add the fact that home prices and interest rates have gone up since the pandemic and there’s a smaller pool of attractive options for homebuyers, you get a better picture of the current situation for people engaged in the housing market.

For those selling their homes, especially in areas where home values are exceptionally high — think California or even its neighbor, Arizona — capital gains tax on home sales will impact the amount they’re able to keep in their pockets after the sale has been made.

Even people outside of high-priced real estate markets are being affected by the capital gains tax on home sales. However, tax breaks may be available to you if you’re in the market to sell your home for more than $500,000. We’ll cover that below.

What is a capital gain?

Capital gain is the profit a person receives from the sale of an asset, such as stocks, real estate, etc. Let’s say you sell your home for $600,000, but you originally bought it for $450,000. Your capital gain would be $150,000.

If, however, you sell an asset for less than what you bought it for, this is a capital loss. Generally, this isn’t something you’d want — but strategically selling assets for a capital loss, called tax-loss harvesting, could counteract your capital gains tax liability. Read more about tax-loss harvesting here.

How much is the capital gains tax on home sales?

It depends. First, you would need to calculate your capital gain (or loss — but hopefully not). You can do so by taking the basis (the amount you paid for the home) and subtracting that from the “realized” amount (the price at which you sold the home).

For example, if Joe and Jane Smith paid $750,000 for their home when they bought it 10 years ago, and they just sold it for $1.3 million, their capital gain is $550,000. With no other deductions, that $550,000 profit is taxable.

The rate at which those capital gains are taxable is impacted by the Smith’s income tax bracket, marital status, length of time they’ve owned the home, and whether it was their primary or secondary residence or an investment property. Generally, the capital gains tax rate ranges from 15% to 20% — with some cases where the tax rate can be 0% or, conversely, reach up to 28%. This depends on factors like filing status and income level, among others.

According to the IRS, “For taxable years beginning in 2023, the tax rate on most net capital gain is no higher than 15% for most individuals.” For a breakdown of the capital gains tax rate per filing status and income level, read more from the IRS here.

How to lessen capital gains tax on home sales

Luckily, the IRS offers home sellers a few ways to reduce — or eliminate entirely! — your capital gains tax liability.

Home Sale Exclusion

The home sale exclusion offers exemptions for people who meet certain criteria. Single filers can receive exemptions of up to $250,000 of the net gains on a sale. For those married filing jointly, it’s up to $500,000. There are, however, some stipulations to receiving the home sale exclusion:

• You must have owned the home and used it as your primary residence for at least two years of the five years prior to the sale of the home.
  • You can meet these two requirements during different two-year stints, as long as they both fall within the five-year period prior to the date of sale.
  • For married filing jointly, only one person must own the home to qualify, but both must have used the home as a primary residence for the required duration.
• You cannot claim this exclusion again if you have already claimed it for the sale of another home within a two-year window immediately prior.
• There are also options to suspend the five-year test period for qualified individuals in intelligence or uniformed and foreign services.

Capital Improvements

Tax deductions can also be claimed for certain improvements made to the home. Not every expense qualifies (think small repairs or painted walls). To qualify for this deduction, improvements to your home must be considered capital improvements — ones that are permanent or structural and that increase the overall value or usefulness of the home.

Let’s say Joe and Jane Smith added a bathroom to their home, renovated the outdated kitchen, replaced the roof, or added insulation to the attic. All of these major improvements increase the value of their home and therefore qualify as capital improvements. This also means that the Smiths can — with proper receipts and documentation — claim the cost of these improvement projects as deductions, which lower the amount of taxes they owe on the sale of their home.