Understanding Capital Gains Taxes and the Home Selling Process

When selling a home, there is a potential to sell a home for a significant profit compared to the purchase cost. When a seller is able to complete a transaction selling a home and net a sizable profit, what do they do with the grim specter of tax liability now hanging over their head? Here's everything sellers need to know about capital gains, and how sellers can maximize tax deductions in the year a home is sold.

Why Do Home Sellers Face Taxes?

Nearly everything bought and sold in the United States faces some kind of taxation. In business, people are required to pay taxes on the money they get for the products and services they sell, minus the amount of money they spent to create the products. Selling a home makes home owners akin to a short-term business owner. As such, sellers are expected to pay capital gains taxes on the amount of money they received for the sale of the home minus the amount of money paid for it. If the seller received the home as a gift, the Internal Revenue Service (IRS) will calculate the difference based on the adjusted cost basis or fair market value of the home at the time of the gift.

How Are Capital Gains Taxes Calculated?

The amount of money sellers have to pay in an effective business tax liability is based on whether or not it was a short-term or long-term asset. If a seller buys the home and sells it several months or a year later, it is considered a short-term asset, which is typically taxed at the normal federal tax rate. Homeowners who owned their homes for at least two years or longer might not have to pay capital gains taxes, depending on their circumstances. If a home seller is in the 15 percent tax bracket or lower, they may have no tax liability on capital gains. People in the 25 percent tax bracket or higher will usually pay a lower tax rate on their capital gains, at 15 percent (or 20 percent for the highest earners).

Will I Owe Capital Gains Taxes?

There is an exclusion of tax liability for people selling a primary residence or a home that was once a primary residence. For those who have lived in a home as a primary residence for at least two years, they can exclude hundreds of thousands of dollars in profit. Sellers only have to consider capital gains taxes on the difference between what was earned as a home seller and what was paid for the home. This may only be tens of thousands of dollars, unless the homeowner owned the home outright or had paid off most of the mortgage. With two years of using the home as a primary residence, sellers could exclude $250,000 from the liability if filing singly, or $500,000 if married and filing jointly. People who live in a home for less than two years before selling can often exclude a portion of this amount.

Do These Laws Apply to All Home Sales?

Any home someone owns and sells is subject to capital gains taxes, and only current or former primary residences are eligible for the tax exclusion. If a home owner claimed a home as a primary residence for two of the last five years and rented it out or used it as a vacation home before selling it, the home seller can still use the exclusion. People who never lived in the home as a primary residence cannot use the exclusion on their taxes.

Selling a home is a good way to earn some serious profits, but capital gains taxes can certainly get in the way. With these tips, sellers should be better able to understand whether or not their home sale will be subject to capital gains taxes and how to minimize liability.