You could owe capital gains tax if you sell a home that has appreciated in value because it is a capital asset. However, thanks to the Taxpayer Relief Act of 1997, most homeowners are exempt from needing to pay it.1
If you are single, you will pay no capital gains tax on the first $250,000 of profit (excess over cost basis). Married couples enjoy a $500,000 exemption.2 However, there are some restrictions. Learn the details below, including the records you should keep while you own a home to help offset any taxes that could be due.
Key Takeaways
- You can sell your primary residence and be exempt from capital gains taxes on the first $250,000 if you are single and $500,000 if married filing jointly.
- This exemption is only allowable once every two years.1
- You can add your cost basis and costs of any improvements that you made to the home to the $250,000 if single or $500,000 if married filing jointly.3
How Much Is Capital Gains Tax on Real Estate?
To be exempt from capital gains tax on the sale of your home, the home must be considered your principal residence based on Internal Revenue Service (IRS) rules. These rules state that you must have occupied the residence for at least 24 months of the last five years.4
If you buy a home and a dramatic rise in value causes you to sell it a year later, you would be required to pay full capital gains tax—short-term or long-term on the house, depending on exactly how long you owned it.However, if you’ve owned your home for at least two years and meet the principal residence rules, you may be able to exclude some or all of the long-term capital gains tax that would be owed on the profit. Single people can exclude up to $250,000 of the gain, and married people filing a joint return can exclude up to $500,000 of the gain.
This rule even allows you to convert a rental property into a principal residence because the two-year residency requirement does not need to be fulfilled in consecutive years, just cumulative months.4
Widowed Taxpayers
Widowed taxpayers may be able to increase the exclusion amount from $250,000 to $500,000 when meeting all of the following conditions.
- They sell their home within two years of the death of their spouse
- They haven’t remarried at the time of the sale
- Neither the seller or their late spouse took the exclusion on another home sold less than two years before the date of the current home sale
- They meet the two-year ownership and residence requirements.7
The 2-in-5-Year Rule
For taxpayers with more than one home, a key point is determining which is the principal residence. The IRS allows the exclusion only on one’s principal residence, but there is some leeway for which home qualifies. The two-in-five-year rule comes into play. Simply put, this means that during the previous five years, if you lived in a home for a total of two years, or 730 days, that can qualify as your primary residence. The 24 months do not have to be in a particular block of time.4
One caveat: For married taxpayers filing jointly to qualify for the $500,000 exclusion, each spouse has to have met the residence requirement, even if only one spouse is the owner of the property. For example, a married couple filing jointly sells their primary residence, which is owned by one spouse. Both spouses have lived in the house for 24 months out of the previous five years, so the couple qualifies for the $500,000 exclusion.
By comparison, a recently married couple filing jointly sell their primary residence, which is owned by one spouse. The owner’s spouse has lived in the house for 24 months out of the previous five years, but the non-owner spouse has only lived in the house for 12 months out of the five years. This couple would not qualify for the $500,000 exclusion, just the $250,000 exclusion for the owner who met the residence requirement.4
How the Capital Gains Tax Works With Homes
Suppose you purchase a new condo for $300,000. You live in it for the first year, rent the home for the next three years, and when the tenants move out, you move in for another year. After five years, you sell the condo for $450,000. No capital gains tax is due because the profit ($450,000 – $300,000 = $150,000) does not exceed the exclusion amount. Consider an alternative ending in which home values in your area increased exponentially.
In this scenario, you sell the condo for $600,000. Capital gains tax is due on $50,000 ($300,000 profit – $250,000 IRS exclusion). If your income falls in the $44,626–$492,300 range, for 2023, your tax rate is 15%.8 If you have capital losses elsewhere, you can offset the capital gains from the sale of the house with those losses, and up to $3,000 of those losses from other taxable income.6
| 2023 Long-term Capital Gains Rates (for Taxes Due in 2024) | |||
|---|---|---|---|
| Filing Status | 0% Tax Rate | 15% Tax Rate | 20% Tax Rate |
| Single | $44,625 | $44,626 to $492,300 | $492,300 |
| Married filing jointly | $89,250 | $89,251 to $553,850 | $553,850 |
| Married filing separately | $44,625 | $44,626 to $276,900 | $276,900 |
| Head of household | $59,750 | $59,751 to $523,050 | $523,050 |
Applicable to the Sale of a Principal Residence
| 2024 Long-term Capital Gains Rates (for Taxes Due in 2025) | |||
|---|---|---|---|
| Filing Status | 0% Tax Rate | 15% Tax Rate | 20% Tax Rate |
| Single | $47,025 | $47,026 to $518,900 | $518,901 or more |
| Married filing jointly | $94,050 | $94,051 to $583,750 | $583,751 or more |
| Married filing separately | $47,025 | $47,026 to $291,850 | $291,851 or more |
| Head of household | $63,000 | $63,001 to $551,350 | $551,351 or more |
Applicable to the Sale of a Principal Residence
Requirements and Restrictions
If you meet the eligibility requirements of the IRS, you’ll be able to sell the home free of capital gains tax. However, there are exceptions to the eligibility requirements, which are outlined on the IRS website.
The main major restriction is that you can only benefit from this exemption once every two years. Therefore, if you have two homes and lived in each for at least two of the last five years, you won’t be able to sell both of them tax free until more than two years have passed since you sold the first one.4
When Is a Home Sale Fully Taxable?
Not everyone can take advantage of the capital gains exclusions. Gains from a home sale are fully taxable when:
- The home is not the seller’s principal residence.
- The property was acquired through a 1031 exchange (more on that below) within five years.
- The seller is subject to expatriate taxes.
- The property was not owned and used as the seller’s principal residence for at least two of the last five years prior to the sale (some exceptions apply).
- The seller sold another home within two years from the date of the sale and used the capital gains exclusion for that sale.9
Example of Capital Gains Tax on a Home Sale
Consider the following example: Susan and Robert, a married couple, purchased a home for $500,000 in 2015. Their neighborhood experienced tremendous growth, and home values increased significantly. Seeing an opportunity to reap the rewards of this surge in home prices, they sold their home in 2022 for $1.2 million. The capital gains from the sale were $700,000.
As a married couple filing jointly, they were able to exclude $500,000 of the capital gains, leaving $200,000 subject to capital gains tax.1 Their combined income places them in the 20% tax bracket. Therefore, their capital gains tax was $40,000.
Capital Gains Tax on Investment Property
Most commonly, real estate is categorized as investment or rental property or as a principal residence. An owner’s principal residence is the real estate used as the primary location in which they live. But what if the home you are selling is an investment property, rather than your principal residence? An investment or rental property is real estate purchased or repurposed to generate income or a profit for the owner(s) or investor(s).
Being classified as an investment property, rather than as a second home, affects how it’s taxed and which tax deductions, such as mortgage interest deductions, can be claimed. Under the Tax Cuts and Jobs Act (TCJA) of 2017, up to $750,000 of mortgage interest on a principal residence or vacation home can be deducted. However, if a property is solely used as an investment property, it does not qualify for the capital gains exclusion.10
Deferrals of capital gains tax are allowed for investment properties under the 1031 exchange if the proceeds from the sale are used to purchase a like-kind investment.11 Capital losses incurred in the tax year can be used to offset capital gains from the sale of investment properties.6 So, although not afforded the capital gains exclusion, there are ways to reduce or eliminate taxes on capital gains for investment properties.
Rental Property vs. Vacation Home
Rental properties are real estate rented to others to generate income or profits. A vacation home is real estate used recreationally and not considered the principal residence. It is used for short-term stays, primarily for vacations.
Homeowners often convert their vacation homes to rental properties when they are not using them. The income generated from the rental can cover the mortgage and other maintenance expenses. However, there are a few things to keep in mind. If the vacation home is rented out for fewer than 15 days, the income is not reportable. If the vacation home is used by the homeowner for fewer than two weeks in a year and then rented out for the remainder, it is considered an investment property.12
Homeowners can take advantage of the capital gains tax exclusion when selling a vacation home if they meet the IRS ownership and use rules. But a second home will generally not qualify for a 1031 exchange (see below).
How to Avoid Capital Gains Tax on Home Sales
Want to lower the tax bill on the sale of your home? There are ways to reduce what you owe or avoid taxes on the sale of your property. If you own and have lived in your home for two of the last five years, you can exclude up to $250,000 ($500,000 for married people filing jointly) of the gain from taxes.4
Adjustments to the cost basis can also help reduce the gain. Your cost basis can be increased by including fees and expenses associated with the purchase of the home, home improvements, and additions. The resulting increase in the cost basis thereby reduces the capital gains.
Also, capital losses from other investments can be used to offset the capital gains from the sale of your home. Large losses can even be carried forward to subsequent tax years.6 Let’s explore other ways to reduce or avoid capital gains taxes on home sales.
Use 1031 Exchanges to Avoid Taxes
Homeowners can avoid paying taxes on the sale of a home by reinvesting the proceeds from the sale into a similar property through a 1031 exchange. This like-kind exchange—named after Internal Revenue Code Section 1031—allows for the exchange of like property with no other consideration or like property including other considerations, such as cash. The 1031 exchange allows for the tax on the gain from the sale of a property to be deferred, rather than eliminated.11
Owners—including corporations, individuals, trusts, partnerships, and limited liability companies (LLCs)—of investment and business properties can take advantage of the 1031 exchange when exchanging business or investment properties for those of like kind.11
The properties subject to the 1031 exchange must be for business or investment purposes, not for personal use. The party to the 1031 exchange must identify in writing replacement properties within 45 days from the sale and must complete the exchange for a property comparable to that in the notice within 180 days from the sale.13
To prevent someone from taking advantage of the 1031 exchange and capital gains exclusion, the American Jobs Creation Act of 2004 stipulates that the exclusion applies if the exchanged property had been held for at least five years after the exchange.14
An IRS memo explains how the sale of a second home could be shielded from the full capital gains tax, but the hurdles are high. It would have to be an investment property exchanged for another investment property. The taxpayer has to have owned the property for two full years, it has to have been rented to someone for a fair rental rate for at least 14 days in each of the previous two years, and it cannot have been used for personal use for 14 days or 10% of the time it was otherwise rented, whichever is greater, for the previous 12 months.15
Since executing a 1031 exchange can be a complex process, there are advantages to working with a reputable, full-service 1031 exchange company. Given their scale, these services generally cost less than attorneys who charge by the hour. A firm that has an established track record in working with these transactions can help you avoid costly missteps and ensure that your 1031 exchange meets the requirements of the tax code.
Convert Your Second Home Into Your Principal Residence
Capital gains exclusions are attractive to many homeowners, so much so that they may try to maximize its use throughout their lifetime. Because gains on non-principal residences and rental properties do not have the same exclusions, people have sought ways to reduce their capital gains tax on the sale of their properties. One way to accomplish this is to convert a second home or rental property to a principal residence.
A homeowner can make their second home into their principal residence for two years before selling and take advantage of the IRS capital gains tax exclusion. However, stipulations apply. Deductions for depreciation on gains earned prior to May 6, 1997, will not be considered in the exclusion.16
According to the Housing Assistance Tax Act of 2008, a rental property converted to a primary residence can only have the capital gains exclusion during the term when the property was used as a principal residence.17 The capital gains are allocated to the entire period of ownership. While serving as a rental property, the allocated portion falls under non-qualifying use and is not eligible for the exclusion.16
How Installment Sales Lower Taxes
Realizing a large profit at the sale of an investment is the dream. However, the corresponding tax on the sale may not be. For owners of rental properties and second homes, there is a way to reduce the tax impact. To reduce taxable income, the property owner might choose an installment sale option, in which part of the gain is deferred over time. A specific payment is generated over the term specified in the contract.18
Each payment consists of principal, gain, and interest, with the principal representing the nontaxable cost basis and interest taxed as ordinary income. The fractional portion of the gain will result in a lower tax than the tax on a lump-sum return of gain. How long the property owner holds the property will determine how it’s taxed: long-term or short-term capital gains.
How to Calculate the Cost Basis of a Home
The cost basis of a home is what you paid (your cost) for it. Included are the purchase price, certain expenses associated with the home purchase, improvement costs, certain legal fees, and more.
Example: In 2010, Rachel purchased her home for $400,000. She made no improvements and incurred no losses for the 12 years that she lived there. In 2022, she sold her home for $550,000. Her cost basis was $400,000, and her taxable gain was $150,000. She elected to exclude the capital gains and, as a result, owed no taxes.
What Is Adjusted Home Basis?
The cost basis of a home can change. Reductions in cost basis occur when you receive a return of your cost. For example, you purchased a house for $250,000 and later experienced a loss from a fire. Your home insurer issues a payment of $100,000, reducing your cost basis to $150,000 ($250,000 original cost basis – $100,000 insurance payment).
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