All About Capital Gains Tax
What are Capital Gains Taxes and Will I have to Pay Them When I Sell My Home?
I’ve had several clients recently who have asked me about potential capital gains they may have to pay when selling their home. I did a deep dive to find some answers and was surprised that there wasn’t really one good place to find all the answers. Here’s what I learned.*
What are Capital Gains?
Simply put, capital gains are the amount of money you profit (GAIN) on the sale of your home (Capital).
According to the IRS, if a home is your primary residence and you have lived there two of the last five years then you do not need to pay taxes on the gain as long as it is $250,000 or less for an individual and $500,000 or less for a married couple filing jointly. This used to be a one time use kind of thing over your lifetime, but since the 1990’s, you can use this exclusion multiple times as long as it is a qualifying sale. So what does this mean?
First of all, it is based on the GAIN not the sales price. If you bought your house for $400,000 and sell it for $600,000, you will not owe capital gains as an individual or as a couple filing jointly. The GAIN is only $200,000 so it doesn’t matter that it sold for more than the max of $500,000 for a couple filing jointly. Most people in Watkinsville and Oconee County are not going to GAIN more than $500,000 when selling their house if they have bought it in the last few years. If you have been in your home for many years though, there are important factors to consider.
Buying a fixer upper
Let’s say that you bought a home for a great deal but it needed work. You fixed up the bathrooms and kitchen, changed all the flooring, and added on to the house. If you paid $300,000 for the house in 2015 and then sold the house in 2023 for $850,000, you may think that you would have to pay Capital Gains even filing jointly because that’s a GAIN of $550,000. However, if you spent $100,000 on all the improvements that you made over the years, your actual gain would only by $450,000 and therefore you would not be subject to capital gains if you were married filing jointly.
Keeping track of normal home improvements
Even if you don’t do any major renovations on your home, many common home improvements like adding a fence or replacing your HVAC system can be deducted from your gain. Replacing a cracked window because your lawnmower threw a rock up and chipped it would be considered maintenance and not a capital improvement. Replacing your windows for better efficiency or because the seals are failing would count as a capital improvement and would therefore reduce the overall gain on your house. As a homeowner, you need to keep receipts of the improvements you do to your home. With home prices having increased as much as they have over the last few years, the improvements you make will probably keep you from having to pay capital gains tax, but the IRS will require you to have proof of those improvements. While reading through this 22 page IRS document, they only list examples but it certainly seems like most improvements you do over the years will count to lower the gain and therefore taxable income you would have on your home if you did sell it for more of a profit than the $250,000/$500,000.
Do I need to buy another home immediately?
I thought for years that to avoid paying taxes on a primary residence you would have to immediately buy another home and put your profit from the first home into the next home. This is NOT the case. Even though buying another home using the proceeds might be a smart thing in order to keep your monthly housing cost down (rent is so high now that if you have a decent down payment, even with higher interest rates it’s normally cheaper to buy than rent), you don’t have to use the profit from your primary home on another home. It’s your money tax-free. Home ownership is the best way for the normal person to generate wealth.
What if I sell my home but I haven’t lived there two years yet?
There is a good chance that you will have to pay taxes (Capital Gains) on the profit from the sale of your home. Because of rising home prices, most people right now who sell their home after only a year will be selling it for more than they paid for it. However, this is another reason it is so important to keep all your receipts on what you have spent on your home. If you added a fence, put in custom shelving, or changed out some light fixtures, you should be able to deduct those costs from your taxable gain. You also can deduct any real estate commissions and some of the closing fees. So, let’s say you bought a house in 2022 for $450,000. You decide that you need to move to get your kids in a better school district or your dream house hits the market. Because homes have appreciated over the last year, you sell your home for $500,000. Good for you that you can make a profit! After you pay realtor commissions ($30,000) and take into account some improvements you made to the property ($10,000), your taxable gain will only be on $10,000. You will not be paying an extra $10,000 in taxes. You will have to pay a maximum of 20% on that $10,000 so your tax burden would only be at most $2,000. Just make sure when you get the profits from the sale, that you set aside that money to have to pay that tax bill in spring of 2024.
What is the Capital Gains rate?
I mentioned that the most you would have to pay is 20%. Most of us are actually going to be paying 15% and sometimes nothing at all. Here’s the rate you would be paying based on your income:
So, if your income is $79,000 or less and you are married filing jointly, in the above scenario, even if you add the $10,000 in profit to your income bringing it to $89,000, you would have a 0% rate meaning you don’t actually have to pay anything.
Does the State of Georgia have any additional taxes on capital gains?
If you live in Georgia, you know that you do have state income taxes. This does include capital gains. After a lot of digging it looks like Georgia charges a 5.75% rate on any capital gains. In the example above, that would mean that saving back an additional $575 to pay towards Georgia taxes in spring of 2024.
Are there any exceptions to the two year rule and paying capital gains?
There are exceptions to people being responsible for the capital gains on selling your home sooner than 2 years of ownership. I have a client whose husband died recently and she is needing to sell her home even though she has not lived there for two years. Because she is a widow, there is a formula that grants her partial exemption. See page 7 of this publication for full details, but she will have the ability to exempt over $330,000 in profit from taxes. Needless to say, she will not owe any taxes at all. There are exceptions for job changes, health issues, divorce and military service.
What if I sell my home and I haven’t even lived there a year?
Most of the time, when you have lived in a home less than a year and make a profit when you sell that home, the IRS is going to consider that a short term gain and you will be taxed on that profit at your normal tax rate which will typically be higher than the capital gains tax rate. Investment properties are even more complicated when it comes to taxes. I’ll be sharing more on that soon. Let me know any questions you might have.
*I am not a CPA or a tax lawyer, but this info is based on personal experience and lots of research.