Capital Gains Tax on Real Estate. How to Legally Differ your Taxes

If you’re a homeowner or real estate investor thinking about selling your property, it’s important to understand the implications of capital gains tax on real estate and how to apply the home sale tax exclusion. Real estate is considered one of the best financial investments you can make, but you don’t want to be caught off-guard by a big tax bill come tax season.

At PropertyCtrl, we’ve done the research to provide you with a solid understanding of how to legally avoid paying a large capital gains tax on real estate when selling your home. However, it’s important to note that we are not Certified Public Accountants or Tax Attorneys, so we always recommend consulting with a professional before making any decisions related to the sale of your home. 

What is a Home Sale Tax Exclusion?

So, what is the Home Sale Tax Exclusion? It’s a potential qualification under Internal Revenue Code Section 121 that allows a taxpayer to exclude up to $250,000 of capital gains from the sale of their primary residence. If married and filing a joint return, this exclusion can be up to $500,000.

What are Capital Gains on Real Estate?

Capital gains on real estate, in simple terms, are the difference between the purchase price and the sale price of a property. For example, if you purchased your home for $100,000 and sold it for $400,000, your capital gains would be $300,000. As a single taxpayer, you may be able to exclude up to $250,000 of this amount, while married taxpayers filing jointly can potentially exclude the entire $300,000.

How to Qualify for a Home Sale Tax Exclusion

Before you can qualify for the exclusion and defer your capital gains on real estate, there are three rules you must meet and be aware of.

1. The Two-Year Ownership Rule

Requires that you have owned the residence for at least two years out of the five years prior to selling it. 

2. Use of the Residence

You must have used the home as your primary residence for at least two years out of the five years prior to the date you will sell the home.

Note that these two years don’t have to be continuous, or have to be the two years immediately before you sell the house.

For example, if you used the house as your primary residence for two years, then you moved out and rented it out for three years (no longer than three years), you can still exclude the gains when you sell the home.

Note that in the example above, you have to sell the home before the three years of you being out of the home are up. If you wait longer than the three years, it would break the five-year prior to the sale rule.

3. Timing of Previous Exclusions

The third rule to be aware of in order to qualify for the Home Sale Tax Exclusion, is the timing in which you have claimed the exclusion from the sale of another property.

If you’re looking to sell a residence, and you meet the previous two rules but you have claimed this exclusion in the last two years on the sale of another home, you will not be able to qualify.

Simply, you can only apply this rule two years after the last time you applied the home exclusion.

Special Circumstances

Married Taxpayers

If you’re married, you may qualify for a higher exclusion of up to $500,000 if you file a joint tax return and both spouses meet the ownership and use of residence rules.

However, in order to qualify you must meet all of the below:

1. File a joint tax return.

2. Either you or your spouse must meet the ownership rule mentioned above. You will want to know that only one spouse needs to meet this rule.

3. Both you and your spouse must meet the use of residence rule mentioned above.

Divorce

If you were given ownership of the home after a divorce settlement, the time your former spouse owned the home can count towards your time you have owned the home in order to pass the two-year ownership rule.

How to Report the Sale

You should always work with your CPA or tax professional in order to report your taxes accurately and avoid any potential audits.

After you have sold the home, the IRS notes that you should always report the sale, and if applicable, pay capital gains tax on real estate. Note again that you have to report it whether it is excludable or not. So, if you received an income-reporting document such as Form 1099-S, you must still report the sale of the home, even if the capital gain can be excluded.

Use Form 1040, Schedule D, Capital Gains and Losses and Form 8949, Sales and Other Dispositions of Capital Assets when required to report the home sale. You can also refer to Publication 523 on the IRS website for the rules on reporting the sale of the home.

In summary, understanding the implications of capital gains tax on real estate and how to apply the home sale tax exclusion can save you from a large tax bill when selling your home. Remember to consult with a professional before making any decisions related to the sale of your property, and always report the sale of your home to the IRS.

We hope this article has helped you and please share or leave us a comment, we’d love to hear from you.

The information provided on this website does not, and is not intended to, constitute legal advice; instead, all information, content, and materials available on this site are for general informational purposes only.