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When selling your home, there’s no doubt that a new coat of paint and a vase of fresh flowers on the table during the open house can help maximize the appeal — and the price.
To get the most from your home sale, though, there’s an even more crucial strategy: minimizing your capital gains tax.
A capital gain is the profit you make from selling an asset. Capital gains are generally taxable. In a previous post, I discussed capital gains tax on investments. As a refresher, if you own an asset for more than a year — which will usually be the case if it is your residence — then your profit is considered a long-term capital gain and will be taxed at a rate of 0% to 20%, depending on your income bracket. (Profits on assets held for less than a year are short-term gains and are taxed at significantly higher rates.)
The tax hit on capital gains can be substantial when home values rise quickly, or if you have held onto a home for a long time. For example, the graph below, from Paragon Real Estate Group, shows specific examples of how much home values increased in San Francisco from the mid-1990s to 2013. For example, one house on Kansas Street sold for $179,000 in the late ’90s and again in 2013 for $755,000, a gain of $576,000 in about 15 years. Overall values have risen even more since 2013. (Note: This graph doesn’t take into account any increases in value due to home improvements.)
So how should you make sure you’re not paying too much in taxes? Here are a couple of key ways.
Track capital improvements
For tax purposes, your capital gain on the sale of your home is the sale price minus your adjusted cost basis. So what exactly is the adjusted cost basis?
Your cost basis starts with the price you paid to buy your home. When you make improvements to your home, the costs of those improvements are added to your basis. Some examples of improvements include replacing a roof or remodeling a kitchen. Repairs and maintenance, however, are not improvements and cannot be added to your basis. Fixing a toilet, for example, is a repair, not an improvement.
The bottom line: The adjusted cost basis is subtracted from the sale price of the home when calculating capital gains. The higher your “adjusted cost basis,” the lower your capital gains and the smaller your capital gains tax.
At the beginning of each year, review home expenses for the past year and enter them into a spreadsheet. If you are not sure whether an expense is a capital improvement or a repair, check with your accountant or consult IRS Publication 523.
There are also things that can reduce your adjusted cost basis (and increase your potential capital gains tax liability). One common situation is when you have taken depreciation on a home office. Those deductions should be subtracted from your basis.
» MORE: Try NerdWallet’s tax calculator
‘Exclude’ some or all of your gain
Most home sellers can exclude a big chunk of their profit from capital gains taxes. This tax break can have huge implications for long-time homeowners in hot real estate markets.
You can exclude $250,000 of your gain from taxes if you’re single, or $500,000 if you’re married, if you meet the following requirements:
- The home is your primary residence.
- You owned the home for at least two years before selling.
- You lived in the home for two out of the five years before the sale (the period of occupancy does not have to be consecutive).
- You have not excluded a capital gain from a home sale in the preceding two years.
You can take a partial exclusion under certain situations, such as a change in employment, even if you haven’t met the ownership/residency requirements.
As with all things having to do with taxes, there is much more to this than can be adequately described in a single post. Consult a qualified tax specialist for questions regarding your particular situation.
Putting it all together
Going back to the graph above, let’s say you bought that house in 1998 for $179,000 and sold in 2013 at $755,000 at a gain of $576,000. During that time, you made $100,000 in improvements. Here are some scenarios that show how taking advantage of tax breaks can save you money:
Scenario 1 – Do Nothing: If you didn’t adjust for cost basis due to home improvements and didn’t use the capital gains exclusion, you would owe capital gains tax on $576,000. If your capital gains rate is 15%, you would owe $86,400 in capital gains tax.
Scenario 2 – Single and Savvy: If you are single and met the criteria for capital gains exclusion, you would owe taxes on: $576,000 – $100,000 – $250,000 = $226,000. At a tax rate of 15%, you would owe about $34,000 in capital gains tax — a savings of $52,000 from the “do-nothing” scenario.
Scenario 3 – Canny Couple : If you are married and met the criteria for capital gains exclusion, you would owe taxes on: $576,000 – $100,000 – $500,000 = less than 0. No capital gains tax owed!
As you can see, keeping track of capital improvements and making sure you qualify for the capital gains exclusion can lead to significant tax savings, especially if you are a long-term homeowner in a rapidly rising market.
Image via iStock.