Tax law is inevitably complicated, but minimizing your capital gains tax obligation upon selling a house boils down to three major steps for the typical U.S. taxpayer:
- Understand when capital gains tax applies in the first place, over and above the exclusion.
- Carefully track all the relevant expenses associated with purchasing, owning, and selling the home.
- Figure out how much taxable profit you actually realized.
We'll address those three here, using as little tax jargon as possible. For details, or to deal with the complexities of your own tax situation and arrange to pay any tax owed, consult an attorney or a tax professional.
Capital Gains Tax as Applied to Home Sales
One's home (residential real estate in the U.S.) is one of many types of assets that, upon being sold for a profit, leads to a so-called "capital gain." Under federal law, you will be expected to pay a percentage of that gain to the Internal Revenue Service (IRS).
However, a special exclusion applies to home sales. If you meet certain qualifications, you can subtract from your sale any profits up to $250,000 (if you file taxes as a single person) and up to $500,000 if you file jointly as a married couple.
The qualifications for using this exclusion include that you have owned and lived in the house for at least two of the five years before selling it, and that you (or your spouse, if you're a joint filer) haven't used the capital gains tax exclusion within the last two years before the sale.
These qualifications aren't entirely hard and fast. You might not, for instance, have to live in the house for a whole two years to claim at least some of the exclusion if your physician recommended that you move for medical reasons. See a lawyer or tax pro if you're not sure whether you qualify to use the exclusion.
Tracking Expenses of Home Ownership and Sale
You probably know how much you paid for the house when you first bought it. But you may have also separately spent money in the process of buying the home, and then more money to "improve" it while living there; and you will no doubt spend more cash yet in preparing the house for sale and closing on the transaction.
Fortunately, many of these expenses can, just like the original purchase price of your home, be subtracted from its selling price for purposes of calculating your taxable "gain."
You will, however, need receipts or other proof of what you've spent. If you haven't kept a file for these, start one now. Include evidence of:
purchase expenses from when you bought the home, some of which will have been wrapped into your closing costs, such as inspection fees, your share of the real estate taxes, settlement fees, title insurance, points or prepaid interest on the mortgage, and your prorated share of the property taxes
capital improvement costs while you owned the home, such as if you added a room, an air conditioning system, or new landscaping (but not including regular home maintenance or repairs)
Calculating Taxable Profit on Your Home Sale
Once your house is sold and you've gathered all the above information, it's a matter of doing the math.
From the selling price, first subtract the exclusion ($500,000 or $250,000, if it applies). Maybe you'll zero out at this point. If not, next subtract the various costs or expenses described above. With any luck, you'll reach zero (or below), and owe no tax at all.
If you still might owe tax, however, take a second look at whether you've remembered or tracked down all the various expenses of your purchase and sale, and consult with a lawyer or other tax expert. Also see IRS Publication 551, Basis of Assets, for more information.