Congrats! Your house is selling for substantially more than you paid for it! That’s a good thing… or is it? There are some scenarios when selling a home will come with hidden fees and tax liabilities.The IRS may want a chunk of the profits in the form of capital gains tax. But there are ways that homeowners can avoid taxes on home sales.

Belongings of significant value are considered “capital assets.” They include things like stocks and bonds and also tangible property like cars, boats, and houses. Selling a capital asset results in a capital gain if it is sold for more than its purchase price. If it is sold for an amount less than what it was bought for, it is a “capital loss.”

The IRS requires taxpayers to report capital gains on their federal income tax returns. Some states do, too. Missouri requires capital gains to be reported and taxes them as regular income. In most cases, capital gains are taxable. Many home sales, however, are excluded from capital gains tax. If a homeowner meets certain IRS requirements, they could be exempt from all or some capital gains tax.

It’s important to understand how the IRS calculates capital gains from a home sale. The first important number in the formula is the cost basis. The cost basis is the original purchase price of the house, plus certain home improvements made over the course of ownership. The IRS has a list of improvements that qualify. 

Let’s look at an example of a home that was purchased for $120,000. Over time, the owner made improvements that cost $30,000. The cost basis of the home will be $150,000.

The owner sells the house for $250,000. Commissions and fees add up to $5,000, so only $245,000 is actually received. The amount of capital gain is $95,000 ($245,000 minus the cost basis of $150,000).

The IRS has very specific rules pertaining to whether homeowners pay taxes on capital gains and how much is owed when they do. Typical homeowners don’t normally end up owing capital gains tax unless the house was purchased many years ago and has increased in value many times over, or if they sell investment property that is not their primary residence. Here’s why:

Capital Gains Tax on a Primary Residence

The IRS excludes up to $250,000 in capital gains for single taxpayers and up to $500,000 for taxpayers who are married and filing jointly. This means there would have to be a huge profit on a home sale to be subject to capital gains tax, as long as the house and the homeowner(s) meet certain criteria. For example, a home purchased for $150,000 and sold for $300,000 years later (by a single person or married couple) would have a capital gain of $150,000 and would not be subject to capital gains tax. The sales price would need to be more than $400,000 for a single person or $650,000 for a married couple before capital gains tax would kick in.

In order to be eligible for the $250,000 exclusion, the home must also be the seller’s primary residence for at least two years. Those years don’t have to be consecutive, but they must occur within the five years leading up to the sale. 

The two-year ownership rule can be costly for people wanting to fix up and “flip” houses quickly for a profit. The amount of capital gain can be reduced by the improvements they make on a fixer-upper, but that also cuts into their profits, which is the whole purpose of flipping houses.

For capital gains that do exceed $250,000 for single taxpayers and $500,000 for married taxpayers who file jointly, how much you owe will depend on how long you’ve owned the home and your tax bracket. A “long-term capital gain” applies to assets held a year or longer and a “short-term capital gain” applies to assets held for less than a year. 

• Long-term capital gains are taxed at lower rates than ordinary income tax rates. These rates are 0%, 15%, and 20%. The exact tax brackets change from year to year, but in 2024, a single taxpayer will be taxed at 0% if their income is less than $47,025, 15% with an income between $47,025 and $518,900, and 20% if they make more that $518,900.

This, however, only applies to capital gains over the $250,000 per person limit. For example, if a married couple sells their home for $600,000 more than the original cost, they will pay tax on $100,000. 

One note about the $500,000 threshold for couples: Until recently, if one spouse passed away, the $500,000 threshold would only apply if the house was sold right away. If the surviving spouse did not sell the home in the same year as the spouse’s death, the threshold would drop to $250,000. A newer law allows the surviving spouse to take the $500,000 exemption for two full years after the death.

• Short-term capital gains are taxed as regular income at a rate based on an individual's tax filing status and adjusted gross income and are not eligible for the $250,000 per person exclusion.

Capital Gains Tax on Investment Properties or Non-Primary Residences

For the sale of a property that you have not lived in for at least two years, but have owned for over a year, the capital gains are taxed the same as the long-term capital gains mentioned above. The main difference is that these properties are not eligible for the $250,000 exclusion. This includes properties like vacation homes or rental properties.

 Capital gains on investment properties that have been in your possession for less than a year are taxed as regular income at a rate based on your tax filing status and adjusted gross income. They are treated the same as a short-term capital gain from a primary residence.

Again, “two” is the magic number. If a homeowner has been exempt from paying capital gains tax on another home sale within the past two years, they can’t take the exemption again. This is more generous than the old rule. Up until 1997, a one-time exemption was allowed, but only for people over 55. Now, taxpayers can move every two years and be exempt from capital gains tax every time.

What happens if you inherit a home that was purchased sixty years ago and its value has increased considerably since then? After all, this is likely not your primary residence. So, it might seem like you are in store for a hefty tax bill.

Fortunately, you are not responsible for tax on the difference between the price when it was purchased and the price that it is sold for. Instead, the “cost basis”, or purchase price, that is used in this scenario is the fair market value of the home when the original owner died. So, if you sell an inherited home shortly after the death of the owner, the capital gains tax is likely to be very little, if anything.

There are some things homeowners can do to mitigate the impact of capital gains tax.

Be Aware of the Timeline

If a homeowner is just a few months shy of the two-year ownership mark, knowing the rules could make a big difference. Waiting to put the house on the market can save a significant amount of money. Also, keep in mind that the one-year mark makes the difference between long and short-term capital gains. This will change the amount of tax owed on any capital gain.

Keep Good Records

Capital improvements made to a house can make a big difference in calculating the cost basis, and therefore the amount of capital gain. The IRS will need proof of upgrades and additions. Keeping track of expenses for any major improvements can help reduce the chances of having to pay capital gains tax.

Ask About Exceptions

There are some exceptions to the IRS rules for capital gains tax. In some cases, a home sale that is necessary due to losing a job or because of an illness might qualify for a special exemption. 

Knowing the rules is one of the most important things a taxpayer can do to avoid a surprise at tax time and also to take advantage of deductions. Each new tax year certain tax laws, rates, and taxable amounts change. It is best to visit the IRS website or talk to an accountant about how current tax laws will affect your tax liability.

Of course, whether your home sale is taxable is an issue only if you manage to sell your home for more than you paid for it. Getting to that point takes a knowledgeable real estate expert. Our agents at Berkshire Hathaway HomeServices Select Properties can get you there. Contact us today to get help selling your property.If a homeowner meets all of the IRS criteria, but their profit exceeds the threshold ($250,000 for singles and $500,000 for married filing jointly,) they will owe long-term capital gains tax on the overage. For example, if a married couple sells their home for $600,000 more than their cost basis, they will pay tax on $100,000.