When selling your home, it is paramount to prepare in advance and formulate strategies to ensure success. Which Realtor® should you hire? When should you sell? How should you price the home? Should you make upgrades or remodel before going on the market? Should you stage the home? Landscape? There are many steps you can take to maximize the value of the home. But in order to net the most from your home sale, though, there’s another crucial strategy that should not be overlooked: planning to minimize your capital gains taxes as currently long-term capital gains tax rates run upwards of 20 percent, depending on your tax bracket.
For homeowners lucky enough to have experienced large gains in the values of their homes in the last decade or two, even in the past few years, there are growing worries about how much of this upside they will have to share with Uncle Sam when they sell their home.
This is especially true in and around cities with thriving economies like New York, Boston, Los Angeles, San Francisco and San Diego, where home prices have increased the most. In these areas, homeowners can be liable for substantial capital gains taxes.
A capital gain in real estate is the difference between the sales price you received and your basis in the asset. The “basis” of a real estate asset is generally the price that you bought it for.
The U.S. Government recognizes the importance of home ownership by providing certain tax breaks when you sell your home.
There are several ways to qualify for these breaks, and keep Uncle Sam at bay, as follows:
1. Using the Capital Gains Exclusion:
If you sold a home before 1997, you may be pleasantly surprised to hear about the generous tax break you can get when selling your home today. The current law–The Tax Payer Relief Act of 1997– went into effect on May 7, 1997.
Here are the capital gains exclusion rules under our current tax law. Your sale qualifies for exclusion of $250,000 gain ($500,000 if married and filing jointly) if the following is true:
- You owned the home and used it as your primary residence during at least 2 of the last 5 years before the date of sale.
- You did not acquire the home through a like-kind exchange (also known as a 1031 exchange), during the past 5 years.
- You did not claim any exclusion for the sale of a home in the past two years. If you recently were married, and your spouse claimed the exclusion in the past two years, you will have to wait until you become eligible again two years from his/her sale.
To use the capital gain exclusion to its fullest potential, tax expert David John Marotta writes in Forbes that you should consider a move whenever you’ve maxed out the capital gain exclusion on your home. Although you need to have lived in your house for at least two years to claim the exclusion, the IRS allows taxpayers to use the exclusion multiple times (but no more than once every two years.) This means you could potentially sell multiple homes at a large gain and never pay a dime in taxes.
As a result of these rules, families who stay in the same home for decades often face huge tax liabilities when they finally sell. More mobile families who are forced to move, or chose to move more frequently, avoid these taxes. The economy on the capital gains tax does not come without any effort and disruption in your family life, and is reduced by the cost of selling and moving repeatedly.
2. Adjusting your Basis with Capital Improvements:
If your capital gains exceed the exclusion amount that is applicable to you, you will want to dig out the receipts for all the capital improvements you have made to your home over the years (there is not time limit) to be able to determine your “total basis” and reduce the amount you owe. The I.R.S., in its Publication 523, defines “total basis” as the total amount you invested in your home, which includes what you paid for your home as well as other money you may have invested in it to improve and add to its value.
Adding value is the key factor to remember here.
It is very important to distinguish between an improvement and a repair for tax purposes. Improvements are allowed to be included in your total tax basis, repairs are not as they do not add value. Understanding the difference between the two is paramount. It can get a bit tricky: painting your home, for example, is considered as maintenance. Refinishing wood floors is maintenance, too, though installing new ones is an improvement that you can add to your total of moneys spent in remodels.
As you can see on the list I have copied from IRS Publication 523 , improvements and additions of all sorts qualify to increase your basis, including decks and patios; landscaping, including sprinkler systems; pools; a new roof or siding; insulation; and kitchen remodeling. Some smaller and perhaps surprising things are there, too, like the installation of utility services.
If you have not been saving your receipts, don’t panic. Start tracking them down, and if you misplaced them, contact the store or contractor who most of the time should be able to provide you with a copy of the receipt. And make sure to keep all the receipts until you sell the home, even after you have discarded your old tax returns.
If you have lived in your home for a long time, you may have forgotten some of the improvements you have made, I see it happen all the time. I recommend you look closely at the IRS publication 523 list to help jog your memory.
If you built your house from the ground up, you can add the cost of the land, all materials and any money you paid to contractors and their laborers plus architect fees. But if you did some of the work yourself, or had a friend or family member who helped you for free, then you are out of luck as the I.R.S. will not recognize the labor cost of that improvement.
If you live in a condominium or cooperative building or a community with homeowners’ association fees, some of your monthly dues and many of your special assessments may also count. Ask the managing agent about this, and require the building or community’s accountant to offer this per capita figure each year in a format that allows you to file it away and keep it.
The catch here is that you need receipts for every one of the upgrades you have made. Most homeowners don’t know about it; nobody tells you this at the closing table–except if you work with an agent like me ; I mention it to my clients. But do you hear it, and remember it?
I would recommend making photocopies of your receipts, as the ink on some old receipts fades away with time, and scanning them to keep a copy in the Cloud as well.
Conversely, if you’ve depreciated the asset (think home office depreciation for example,) or claimed some energy credits, you will have to deduct the amount depreciated from your basis.
3. Deducting your Home Selling Expenses:
- appraisal fees
- attorney fees
- closing fees
- document preparation fees
- escrow fees (if paid by seller)
- notary fees
- points paid by seller to obtain financing for buyer
- real estate broker’s commission
- recording fees (if paid by the seller)
- costs of removing title clouds
- settlement fees
- title search fees, and
- transfer or stamp taxes charged by city, county, or state governments.
Most of these costs will be listed in the closing statement prepared by the escrow company, bank or other financial institution, (or attorney, in some states) when you sell your house. Make sure you hold on to your closing statement. If you misplace it, contact your real estate agent to obtain another copy at tax time.
4. Doing a 1031 exchange:
If you sell rental or investment property, you can avoid capital gains and depreciation recapture taxes by rolling the proceeds of your sale into a similar type of investment within 180 days. This like-kind exchange is called a 1031 exchange after the relevant section of the tax code, and it is one of the most underutilized sections of the code.
Perhaps the problem lies with calling the procedure an exchange as this creates a lot of misunderstanding and would be better utilized if this was re-labeled as a 1031 rollover because that is precisely what happens. The gain is rolled over to a new property. An individual can successfully rollover gain and postpone tax for an unlimited number of times. The ultimate goal is to make this tax disappear by one of two ways:
- Sellers may successfully rollover gain and ultimately move into one of their investment properties and declare it to be their primary residence. Provided they are married and have held the property for five years, reside in the property for a minimum of two years, they can exempt $500,000.00 in taxes upon the ultimate sale.
- Capital gains taxes are eliminated upon the death of the property owner. Heirs receive a step up in basis on the date of death.
If you want to enjoy the benefits of a 1031 exchange with your primary residence, you can move out and rent it for two years.
5. Doing an Installment Sale:
I would be remiss not to include a paragraph about installment sales in this article, even though I believe this is a more complicated, and risky, solution. Installment sales of real estate are a form of seller financing. Instead of borrowing money from a bank or other financial institution to pay the seller, the buyer borrows from the seller. The buyer and seller enter into an installment agreement in which the buyer agrees to make a down payment and pay the remainder of the sales price over a term of years. It can be one year or hundred, it’s up to the buyer and seller to decide. The buyer also agrees to pay interest on the payments. Again, it’s up to the buyer and seller to agree on the interest rate—it can be higher or lower than the rates mortgage lenders charge. The seller ordinarily takes back a purchase money mortgage from the buyer. This way the buyer’s promise to pay the seller is secured by the property—that is, if the buyer doesn’t pay, the seller can foreclose and get the property back.
This is an option used by sellers who cannot benefit from the tax exclusion or for whom the proceeds of the sale would make them jump into a higher tax bracket if they received it all in one year. For more information, see IRS Publication 537 – Installment Sales and make sure to consult your CPA and/or financial advisers.
6. Not Selling in Your Lifetime:
Most people die holding highly appreciated investments, including their home. When you die, your heirs get a step up in cost basis, which is the property’s fair market value at the time of your death. When your heirs sell, they only pay taxes on gains over that stepped-up basis and avoid paying capital gains taxes on a lifetime of appreciation.
However, it can be quite emotionally, financially and even physically difficult for heirs to sell their parents’ home, especially if the home is chock full of belongings they will need to dispose of. Some people prefer to bite the bullet, empty their home, sell it and move to a retirement home to save their children from the burden of emptying the house.
For example, let’s assume you are single and your Marin County home has a basis of $550,000. Its current market value is $1,000,000 at the time of your death (current market value,) and your heirs will get a stepped up basis of $1,000,000. If they sell the property for a $1,000,000 they owe no capital gains tax. Had you sold the property for $1,000,000, assuming you had $50,000 in improvements, you would likely have owed taxes on the fair market value minus the total basis minus the $250,000 deduction as a single person: $1,000,000 – ($550,000 + $50,000) – $250,000 = $150,000. Assuming you were in the 20 percent tax bracket, that would have meant paying capital gain taxes of $30,000.
This is not an easy decision to be made, and I often advise my clients to consult their financial adviser to discuss their overall financial picture, and also to discuss it with their heirs. Call your Realtor also to find out how much your home is worth in today’s market so that you can make an educated decision,
Please note that if you are married and own your home as community property, when the first spouse dies, the basis is stepped up. However, if the home is not held as community property, only the dead spouse’s half of the home gets stepped up.
In conclusion, let me add that we need to keep in mind that because we are talking about taxes here, there will be exceptions, carve-outs and exceptions to the carve-outs issued in I.R.S. private letter rulings and whatnot. I recommend you consult a tax professional, whether or not you fall into any of the following categories which will complicate things even further: widows or widowers, divorcees, newly remarried couples who already have homes, members of the military, people who have moved for job transfers, nursing home residents who have kept the homes they used to live in, people who sold a home before 1997 and rolled their capital gain over into the home they live in now and people who rebuilt after a fire, flood or other similar event.
Check with your accountant also if you have incurred a capital loss in the past (from the sale of assets, including stocks) as you may be able to offset that loss against the gain from the sale of your home.
The information contained in this article is believed to be accurate but should not be considered as tax advice, as every person’s individual tax situation is different. You should consult a qualified tax accountant or CPA before acting on any of the information included herein.
If you are considering selling, let’s strategize on how to prepare and price your home for maximum returns. If it’s time to buy, let me know so I can give you the inside info on each neighborhood that may be right for you. In the meantime, have a wonderful summer.
Other helpful Real Estate Tax Related Resources/Articles
Real Estate Capital Gains and Your Home Sale by Bill Gassett
Capital Gains and Your Home Sale via Bankrate
Owner Financing: the Ultimate Guide to Seller Financing via FitSmallBusiness.com
This article was updated on October 30, 2017.
About the Author: The above article about Six Ways to Minimize Your Capital Gains Taxes When Selling Your Home was provided by Sylvie Zolezzi. I am an award winning, top producing Realtor specializing in luxury residential real estate in beautiful Marin County, just north of the Golden Gate Bridge.
I offer a wide range of innovative and comprehensive real estate solutions for buyers, sellers and investors, attracting clients who demand excellence—in marketing, negotiations, market knowledge—and a genuine concern for their needs. My association with Decker Bullock Sotheby’s International Realty allows me to provide a high-end luxury experience to all my clients at every single price point. It also empowers me to leverage the unique combination of Sotheby’s global resources, Decker Bullock Sotheby’s International Realty’s growing market share and local knowledge with my unmatched social media networks to provide highly personalized service and unmatched exposure to my clients’ properties locally and worldwide.
I would welcome the opportunity to show you how I consistently get outstanding Real Estate results for my clients. I can be reached via email at Sylvie@YourPieceOfMarin.com or by phone/text at 415.505.4789.