High home values could lead to some tax surprises.
Fidelity Viewpoints
Key takeaways
- After the rapid rise in home prices during the COVID years, more owners may find their home appreciation has exceeded the limits of the primary residence tax exclusion.
- The cost of remodels and improvements while you own your home can increase your cost basis and help reduce a potential tax bill.
- Be sure to consult with a tax professional to better understand your personal situation.
While the housing market has undoubtedly slowed in the past year, prices in many areas are still elevated.
Accumulated appreciation means owners may need to anticipate a capital gains tax bill when they eventually sell. Growth in the value of property means owners make more at the sell, but could possibly owe more, as well.
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Could you owe capital gains tax on your home?
There's an exclusion on gains from the sale of a primary residence, which generally lets sellers exclude up to $250,000 in gains from their income (or $500,000 for certain married taxpayers filing a joint return and certain surviving spouses).1
In the past, long-time homeowners could have potentially sold without tax consequences, however now, the dramatic increase in prices may have more sellers closer to the exclusion limits. (The current exclusion amounts have been in place for more than 25 years, and were adopted in the Taxpayer Relief Act of 1997.2)
The exclusion is intended to apply to the home you live in, not investment properties. To qualify for it you must meet the IRS's ownership and use tests. The exclusion rule generally allows a taxpayer to exclude from gross income gain realized from the sale or exchange of property if, during the 5-year period ending on the date of the sale or exchange, the property has been owned and used by the taxpayer as their principal residence for a period totaling 2 or more years. The exclusion is allowed each time a taxpayer meets the eligibility requirements, but generally no more often than once every 2 years.3There are no income limitations, and an owner may rent or use the property as a non-primary residence following the period of primary residency without consequence up to the end of the 5-year period, and still claim the exclusion.
How much capital gains tax could you owe?
If you do have to pay capital gains tax, how much you owe will depend on how long you owned the house, your filing status, and your income.
Selling a house you've owned for 1 year or less generates the steepest potential tax rate. In that case, you don't qualify for the exclusion and gains are considered short term, meaning they'll be taxed at federal ordinary income rates—running as high as 37%. If you've owned the home for more than 1 year but less than 2, you still don't qualify for the exclusion, but you may pay the lower, long-term federal capital gains rates on gains.
In addition to federal income or capital-gains tax, state taxes and the 3.8% Net Investment Income Tax may apply. If you rented the property at any point and claimed depreciation, you may be subject to depreciation recapture at federal ordinary income rates up to a maximum of 25%. You don't have to pay taxes on any amount of the sale proceeds below your adjusted basis (more on that below).
| Potential tax exposure at a glance | ||
| If you've owned your home… | ||
| 1 year or less
| More than 1 but less than 2
| At least 2 years
|
(Learn more about ordinary income tax rates and strategies for managing capital gains tax exposure.)
Ways to potentially reduce capital gains tax on home
Calculating your gain is more complicated than taking the sale price and subtracting your original purchase price. Instead of selling price, taxes will be based on the "amount realized" on the sale, accounting for many selling expenses.4 Instead of original purchase price, sellers subtract their "adjusted basis," which factors in the purchase price, certain purchase expenses, and the cost of any home improvements.5
There are potentially 3 stages along the way of the homeownership journey when it makes sense to keep track of relevant expenses.
Expenses and improvements that could help reduce potential tax exposure6
When you buy
Keep records of your closing costs, as you may be able to use some of these to increase your cost basis when you sell, potentially including:
- Title fees
- Legal fees
- Recording fees
However, you can't generally factor in costs related to financing, like mortgage origination fees.
While you own
Keep good track of any improvements you make over the years, like:
- Remodeling
- Additions
- Landscaping improvements
- New heating, AC, or other systems
- New roof or siding
- Energy-efficiency improvements
You don't get any benefit for regular maintenance and repairs, like painting or fixing a broken structure.
When you sell
Thankfully, you can subtract many selling expenses in figuring the amount you actually realized from the sale (which is what really matters), such as, potentially:
- Real estate agent commissions
- Legal fees
- Advertising fees
- The costs of staging your home
As any seller knows, those expenses can add up. So keep scrupulous records of what you spend at this stage.
Even if you have no plans to sell soon, try to keep track of money you invest in your home, particularly major remodeling or renovations.
To ensure you have the proof you need to get an adjustment, make sure to keep detailed records of the dates and descriptions of any improvements, as well as the companies that performed the work and your paid invoices. The important thing is to keep your records organized (copies of permits, blueprints, and photos, even though they're not required), so another person could make sense of them if you ever need to provide proof of your improvements.
Be aware that gain from the sale or exchange of a principal residence allocated to periods of nonqualified use (such as use as a second home, vacation home, or rental property) is not excluded from gross income and you may only be allowed to claim a portion of the exclusion.7 The portion of gain from the sale of property attributable to depreciation after May 6, 1997, is not eligible for the exclusion.8
A tax professional can better help you understand your personal situation—not only in terms of working out your adjusted cost basis, but also in understanding the impact of any gains on your taxes.
Offsetting capital gains with losses
Homeowners can potentially offset capital gains on their home with realized capital losses on securities or other assets. This may be possible if you sell other assets at a loss in the same year you sell your home, or if you have losses from previous years that you've carried forward for tax purposes. If you're considering pursuing tax-loss harvesting by selling securities, be mindful of potential wash sales and make sure not to throw off your investment plan. Consider working with a financial professional to identify a tax-loss harvesting strategy that's consistent with your long-term investment goals.
