Capital Gains Tax on Home Sales

When it comes to the sale of your primary home, homeowners often wonder how they can minimize or avoid capital gains tax. Lucky for them, the U.S. tax code provides a favorable provision known as the sale of residence exemption, which allows homeowners to exclude a portion of the capital gains on the sale of their primary residence from being taxed. Let’s dive deeper to understand how much of these gains you can exclude and the criteria you must meet.

How Much Capital Gain Can I Exclude?

If you have a capital gain from selling your main home, you may qualify to exclude up to $250,000 of that gain from your income or up to $500,000 if you file a joint return with your spouse. This is called the home sale exclusion.

To qualify for the home sale exclusion, you must meet certain requirements, such as:

• You must have owned and used your home as your main home for at least two years out of the five years before its date of sale.
• You must not have excluded the gain from the sale of another home during the two years before the sale of your home.
• You must report the home’s sale on your tax return, even if the gain is excludable.

How Do I Qualify for Avoidance of Capital Gains Tax?

Avoidance of capital gains tax means legally reducing or eliminating the tax you have to pay on the profit you make from selling an asset that has increased in value. There are different ways to avoid capital gains tax depending on the type of asset, the amount of gain, and the duration of ownership.

One of the most common types of asset that generates capital gains is an investment property, such as a rental house or a commercial building. If you sell an investment property, you may have to pay capital gains tax on the difference between the sale price and the property’s adjusted basis. The adjusted basis is the original cost of the property plus any improvements or expenses you made to increase its value.

Some options to legally avoid paying capital gains tax on your investment property sale are listed below.

Buying Your Property with a Retirement Account

If you use a traditional IRA or a 401(k) plan to buy an investment property, you can defer paying taxes on any gains until you withdraw money from the account. If you use a Roth IRA or a 401(k) plan, you can avoid paying taxes on any gains if you follow the rules for qualified distributions.

Converting the Property from an Investment Property to a Primary Residence

If you live in your investment property for at least two out of the five years before its sale, you may qualify for the home sale exclusion, which allows you to exclude up to $250,000 of capital gains if single or up to $500,000 if married filing jointly. However, this option may not be available if you used depreciation deductions on the property while it was rented out.

Utilizing Tax Harvesting

Tax harvesting, or tax loss harvesting, is a strategic method investors use to minimize capital gains taxes. By understanding how it works, investors can utilize this tactic to offset their gains and optimize their portfolio’s after-tax returns.

Tax harvesting is fairly straightforward: selling an investment at a loss to offset the capital gains you might incur from selling another investment at a profit. Doing this reduces the capital gains tax you owe for the year.

For instance, if you sell Investment A and realize a capital gain of $10,000 but then sell Investment B at a $10,000 loss, these transactions would effectively cancel each other out for tax purposes. Thus, you’d owe no capital gains tax on the profit from Investment A.

A compelling aspect of tax harvesting is the ability to carry over any unused capital losses. If your losses in a particular year exceed your gains, the IRS allows you to use up to $3,000 of the net capital loss to reduce other income. Any loss greater than that can be carried over into subsequent years until the loss is fully utilized.

While tax harvesting can be a valuable strategy, ensuring the decisions align with your overall investment strategy is essential. Don’t sell an asset solely for tax reasons if it doesn’t make sense from an investment perspective. Also, be aware of the “wash sale” rule. This IRS rule prohibits investors from claiming a loss on a sale of an investment and buying the same or a substantially identical investment within 30 days before or after the sale.

Using Section 1031 of the IRS Code for Deferring Taxes

This means exchanging your investment property for another property of equal or greater value and similar use without receiving any cash or other property in return. This way, you can defer paying taxes on the gain until you sell the new property. However, this option has strict rules and deadlines that you must follow.

These are ways to avoid paying capital gains tax on investment property sales. However, each option has its own advantages and disadvantages and may not suit your specific situation. Therefore, it is advisable to consult a tax professional before making decisions.

Exceptions to the Ownership and Use Tests

The ownership and use tests are the requirements you must meet to qualify for the home sale exclusion, which allows you to exclude up to $250,000 of capital gain ($500,000 if married filing jointly) from the sale of your main home. The tests are:

• You must have owned the home for at least two years (the ownership test).
• You must have lived in the home as your main home for at least two years (the use test).

However, some exceptions and special rules may apply to your situation.
If you sold your home due to a work-related move, a health-related move, or an unforeseeable event, you may qualify for a partial exclusion of gain.

If you or your spouse are on qualified official extended duty in the Uniformed Services, the Foreign Service, or the intelligence community, you may elect to suspend the five-year test period for up to 10 years.

If you sold your home under a contract that provides for part of the selling price to be paid in a later year, you made an installment sale and may have to report the gain over several years.

For more information about the home sale exclusion and determining your gain or loss, refer to Publication 523, which provides rules and worksheets. You can also visit IRS.gov for more tax topics and resources.

Seeking Legal Help

Capital gains tax laws and the sale of residence exemption can be complex, especially when considering the exceptions to capital gains tax and other potential deductions. If you’re unsure about your situation or believe you qualify for an exception, consulting with a professional is wise.

Considering a home sale and unsure about potential tax implications? Don’t handle this situation on your own. Through LegalMatch, you can easily find a tax lawyer who will guide you every step of the way.

Ensure you’re making informed decisions and maximize your financial benefits. Contact a tax lawyer through LegalMatch today.