If you decide to sell your house to simplify life, lock in gains, downsize, or relocate for a job, this article will help you minimize your capital gains tax bill. You may even be able to pay no capital gains tax after selling your house for big bucks.
According to the IRS, most home sellers do not incur capital gains due to the $250,000 and $500,000 exclusion for single and married couples. This makes sense since the median home price is roughly $350,000 in 2021.
If you make more than $250,000 – $500,000 on a median-priced home, it is extremely rare. However, as the housing market continues to go up, more people may potentially face a capital gains tax bill.
Conditions To Sell A Home Using The Tax-Free Exclusion
To be eligible for tax-free profits up to $250,000 / $500,000 for singles / married couples, there are three conditions that need to be met.
- Ownership. You must have owned the home for at least two years during the five years prior to the date of your sale. It doesn't have to be continuous, nor does it have to be the two years immediately preceding the sale.
- Use. You must have used the home you are selling as your principal residence for at least two of the five years prior to the date of sale.
- Timing. You have not excluded the gain on the sale of another home within two years prior to this sale.
But let's say you plan to sell a property where your gains are much greater than $250,000 / $500,000. Fear not! There's still a good chance you still won't owe much in capital gains tax if any. Let's go through how with an example.
Important Documents To Have After A House Sale
If you have greater than a $250,000 / $500,000 capital gain, the title company will most likely send you a 1099-S. This document tells the IRS the final sale price of the home plus any real estate taxes you may have paid. If you don't receive a 1099-S, call the title company and ask for one. Your records and the IRS's records must match.
While you're at it, ask the title company for the HUD-1 settlement statement or Closing Disclosure. The document will show the date you purchased the home and for exactly how much. Knowing the correct purchase date and cost basis are a must when you do your taxes.
Dig Up All Home Improvement Records And Receipts
Now that you have the documents above, it's time to dig deep into your home records. Find out how much you spent on construction, renovation, improvements, and any special assessments you've paid for local improvements. Your goal is to gather as many receipts and records as possible about your home.
All these expenses INCREASE your cost basis, thereby DECREASING your capital gains and your capital gains tax. For example, if you spent $100,000 on home improvement, the cost of your $1 million home increases to $1,100,000. As a result, your tax liability will decrease by $100,000 X your tax rate.
The problem many long-term homeowners face is not keeping proper records of all their expenditures over the years. For example, it's hard to remember exactly how much you spent remodeling a bathroom 30 years ago. And oftentimes, the company who did work for you may have gone out of business. Or if you used an individual, that individual may have retired, left the country, or switched professions.
Hence, contact all your vendors today and ask for any missing receipts and plans. Even if you don't plan to sell for a while, you need to get caught up with all of your expense records.
Always take pictures of each receipt and keep a spreadsheet of all your home improvement work. The spreadsheet should include a date for when work was completed, the description of the work, the vendor, and the cost.
Worst case, you can estimate how much the home improvements cost and when you did them.
Example Of A Profitable Home Sale Gain With No Tax Liability
Here's an example of a $1,800,000 home sale that was originally purchased for $800,000 in 2005. This price appreciation is quite typical in more expensive coastal cities like SF and NYC. The sellers are a married couple.
Despite a handsome $1,000,000 gross profit, the home seller pays $0 federal and state capital gains tax. This is huge, especially if the long-term capital gains tax rate gets hiked. Study the chart carefully, and let's discuss the line items below.
Cost To Sell A Home
Despite negotiating a total commission cost of 5% ($90,000), it still costs an absurd $105,000 to sell this $1,800,000 home. The costs include commission, inspection, 3R and NHD reports, staging, water compliance, and transfer taxes.
The transfer tax is particularly arbitrary and onerous for higher-priced homes. It is based on a percentage of the selling price, e.g. NY City realty transfer tax: 1% to 2.625% based on +/-$500K home value and type of property.
Just remember that the costs to sell a home are negotiable between the real estate agent and the homebuyer. Absolutely do not agree to a selling commission of 6%. The most you should pay nowadays is 5%. However, paying a 4.5% selling commission can be negotiated for higher-priced homes ($1M+).
You can always use a platform like Redfin to sell your home as well. They charge 3.5%.
Construction, Renovation, and Home Improvement Cost
Over a 15-year time period, this homeowner spent $373,000 making their home perfect. It feels wonderful living in a completely remodeled home compared to an aging rental. For many people, as their wealth grows their tastes also grow over time. The global pandemic saw a massive home remodeling boom as people spent more time at home.
Most of these home improvements increase the cost basis for the homeowner. At the same time, home remodeling also increases the value of the home. But usually by not as much as the cost. To get top dollar after a home remodel usually requires selling the home immediately after the remodel is done.
Special Assessments From The City
$5,000 was assessed by their city to pay for a water treatment plant overhaul and water sewage pipe replacements.
Cost To Purchase The Home In 2003
The seller bought the home for $800,000 in 2003. Typically, a home buyer will pay between about 2 to 3 percent of the purchase price of the home in closing fees. This homeowner paid 1 percent of the purchase price in closing fees due to some negotiating. Here are some typical fees homebuyers may face.
- Application Fee: This fee covers the cost for the lender to process your application. It can often include things like a credit check for your credit score or appraisal as well.
- Appraisal: This is paid to the appraisal company to confirm the fair market value of the home.
- Attorney Fee: This pays for an attorney to review the closing documents on behalf of the buyer or the lender. This is not required in all states.
- Closing Fee or Escrow Fee: This is paid to the title company, escrow company, or attorney for conducting the closing. The title company or escrow oversees the closing as an independent party in your home purchase. Some states require a real estate attorney to be present at every closing.
- Courier Fee: This covers the cost of transporting documents to complete the loan transaction as quickly as possible.
- Credit Report: A Tri-merge credit report is pulled to get your credit history and score. Your credit score plays a big role in determining the interest rate you’ll get on your loan.
- Escrow Deposit for Property Taxes & Mortgage Insurance: Often you are asked to put down two months of property tax and mortgage insurance payments at closing.
- FHA Up-Front Mortgage Insurance Premium (UPMIP): If you have an FHA loan, you’ll be required to pay the UPMIP of 1.75% of the base loan amount. You are also able to roll this into the cost of the loan if you prefer.
- Flood Determination or Life of Loan Coverage: This is paid to a third party to determine if the property is located in a flood zone.
- Home Inspection: You will likely get your own home inspection to verify the condition of a property and to check for home repairs that may be needed before closing.
- Homeowners’ Insurance: This covers possible damages to your home. Your first year’s insurance is often paid at closing.
- Lender’s Policy Title Insurance: This is insurance to assure the lender that you own the home and the lender’s mortgage is a valid lien, and it protects the lender if there is a problem with the title. Similar to the title search, but always a separate line item.
- Lead-Based Paint Inspection: Covers the cost of evaluating lead-based paint risk.
- Loan Discount Points: “Points” are prepaid interest. One point is one percent of your loan amount. This is a lump-sum payment that lowers your monthly payment for the life of your loan.
- Owner’s Policy Title Insurance: This is an insurance policy that protects you in the event someone challenges your ownership of the home. It is usually optional.
- Origination Fee: This covers the lender’s administrative costs. It’s usually about 1 percent of the total loan but you can sometimes find mortgages with no origination fee.
- Pest Inspection: This fee covers the cost to inspect for termites or dry rot, which is required in some states and required for government loans.
- Prepaid Interest: Most lenders will ask you to prepay any interest that will accrue between closing and the date of your first mortgage payment.
- Private Mortgage Insurance (PMI): If you’re making a down payment that’s less than 20% of the home’s purchase price, chances are you’ll be required to pay PMI. If so, you may need to pay the first month’s PMI payment at closing.
- Property Tax: Typically, lenders will want any taxes due within 60 days of purchase by the loan servicer to be paid at closing.
- Recording Fees: A fee charged by your local recording office, usually city or county, for the recording of public land records.
- Survey Fee: This fee goes to a survey company to verify all property lines and things like shared fences on the property. This is not required in all states.
- Title Company Title Search or Exam Fee: This fee is paid to the title company for doing a thorough search of the property’s records. The title company researches the deed to your new home, ensuring that no one else has a claim to the property.
- Transfer Taxes: This is the tax paid when the title passes from seller to buyer.
- Underwriting Fee: This also goes to your lender, covering the cost of researching whether or not to approve you for the loan.
Phew! That's a lot of fees. No wonder why the real estate market has powerful lobbyists to keep transaction costs high.
In hot real estate markets, some homebuyers will skip the home inspection, appraisal fee, origination fee, pest inspection, application fee, and more because they are paying cash and need to make their offer as competitive as possible.
Home Profit Before Tax-Free Profit Exclusion Rule
Without the $500,000 tax-free profit exclusion for married couples, the home seller would have to pay taxes on $499,000 in capital gains. At an 22% total effective tax rate (federal + state), we're talking $109,780 in taxes.
If the couple was in the top marginal tax bracket, they would have had to pay a 20% federal capital gains tax rate + 13% state tax, or $164,670 in taxes. But thanks to the tax-free profit exclusion and all the costs associated with the home, the tax liability is $0.
It takes $640,000 in capital gains taxed at a 22% total effective tax rate to net $499,000. It takes $745,000 in capital gains at a 33% total effective tax rate to net $499,000. Therefore, the tax-free profit exclusion for primary residences is a huge incentive for the after American homeowner.
Net Proceeds After Tax
After coming up with a $160,000 down payment on the $800,000 home in 2003, the seller walks away with $895,000 in net proceeds.
Of course, the home improvement expenses cost them $373,000 over a 15 year time period. But during that time, they improved their home lifestyle. If we add the downpayment to the home improvement costs, the home seller still comes away $362,000 richer. Not bad after 15 years of living.
Compare a $362,000 gain with a $1,080,000 loss if you were to rent the house for $6,000/month for 15 years. That's a $1,442,000 swing.
But at the end of the transaction, the home seller walks away with $895,000, not $362,000. It's kind of like getting a large tax refund, but actually enjoying the money throughout the year.
The $895,000 can be rolled into other investments like stocks, bonds, and real estate crowdfunding. Reinvesting 100% of my home proceeds is exactly what I did in 2017 when I sold a rental. Or, the proceeds can be spent to enjoy life more.
Whatever the case may be, having an $895,000 windfall is huge for most households. Suddenly, college tuition for multiple kids can now be fully paid for. Medical insurance for a couple in retirement is now covered. Now you can see the wealth-building power of homeownership over time. Hopefully, the renter invested their cash flow wisely during this time frame.
Lower Your Active Income The Year You Plan To Sell Your House
The final strategy to pay no capital gains tax after selling a home is to reduce your income the year of the home sale. For this to happen, you must plan ahead and have flexibility with your income. Ideally, you want to make as little W2 or 1099-MISC income as possible during the year of the home sale.
Further, once a couple's income is over $250,000, they've got to pay an additional 3.8% Net Investment Income Tax (NIIT, Form 8960) on every dollar above $250,000. In addition, the couple will also face a higher marginal income tax rate. The income threshold for the NIIT is $200,000 if you are single.
Here’s an example where a single person made $141,827 in net investment income from his home sale. He then made $167,724 in W2 and 1099-MISC income for a total MAGI of $319,551. Given the income threshold is $200,000, he has to pay an additional 3.8% NII tax on $119,551 ($319,551 – $200,000). His additional NIIT bill is, therefore, $4,543.
If this individual did more proper planning, he could have lowered active income to $58,173 ($200,000 – $141,827) to avoid paying the NIIT. During the house sale year, he could have worked less and increased his business expenses. He could have pushed out his 1099-MISC freelance income to the following year or deferred his December paycheck to January.
Business owners and freelancers have more flexibility in adjusting their incomes than day job workers. Therefore, I encourage everyone to start their own business or work on some side hustles. Accurate active income and passive income forecasting are important to minimize tax liability.
The 1031 Exchange Is Still A Possibility
If your property sale is a rental property, then you can consider doing a 1031 Exchange where you defer capital gains tax indefinitely.
In my case, I decided not to do a 1031 Exchange when I sold my rental property in 2017. I wanted to simplify life. Trying to identify three properties to buy within 45 days after the sale was difficult. Then actually having to buy one within 180 days to complete the 1031 Exchange felt too rushed.
Therefore, I reinvested 100% of the proceeds into building more passive income. In retrospect, I'm glad I did. As a new father, managing a rental property with five rowdy dudes was no fun. Further, the investments have performed just as well.
Final Way To Avoid Capital Gains
If you want to pay no capital gains tax after selling your home for big bucks, please keep detailed receipts of all your home remodeling expenses. Take full advantage of the $250,000 / $500,000 tax-free profit exclusion rule until it changes as well. Also plan to make as little active income as possible the year of your home sale.
Better yet, if you want to guarantee never having to pay a capital gains tax, never sell! The longer you can hold onto your home, usually the better for your wealth anyway. There might come a point where you are so rich that your estate might have to pay a death tax. However, let's cross that bridge when it comes.
Two Best Real Estate Investing Platforms
If you're looking to invest in real estate, check out Fundrise. Fundrise is the leading real estate crowdfunding platform and creator of the private eREIT asset class. Gain real estate exposure through Fundrise with as little as $500.
My other favorite platform is CrowdStreet. CrowdStreet focuses specifically on real estate opportunities in 18-hour cities. 18-hour cities are secondary cities with lower valuations, higher rental yields, and potentially higher growth due to job growth and demographic trends.
Personally, I've invested $810,000 through real estate crowdfunding to diversify away from my San Francisco-heavy real estate exposure. Further, I'm looking to boost passive income as I head to retirement.
For more nuanced personal finance content, sign up for the Financial Samurai weekly newsletter. How to Pay Not Capital Gains Tax After Sell Your Home is a FS original post. I've been helping people save, earn, and achieve financial independence since 2009.