When you sell a home, one of the big concerns is how much you’ll owe in taxes. It’s a little complicated, but the good news is that there are special rules for real estate. Those rules may reduce your tax bill, or eliminate it altogether.
Important note: This information is strictly for educational purposes. You should use a tax professional, such as an Enrolled Agent, to understand how these rules apply to your unique situation.
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What Are Capital Gains Taxes?
Capital gains taxes are taxes on the increase in value of an investment. Capital gains tax rates can range from 0% to 20%, based on your total income. Real estate is considered an investment property, even if you live in it.
Of course, we all hope that the value of a home will go up! But with that increase in value comes the possibility of taxes on the increase. But those special rules for real estate may lower your tax bill if you have used it as your primary residence.
The Primary Residence Rules
Under these special rules, a taxpayer (or taxpayer couple) can exclude up to $250,000 in capital gains ($500,000 per couple) if they have used the property as a primary residence for two years within the last five years. More accurately, you must have used the property as your primary residence for 24 months out of the last 60 months. If using the higher amount for two owners, the couple must be married and file their taxes jointly.
For example, if you lived in your house from June 2018 to June 2020, and then sold it in 2022, you would qualify for the exemption. You have two years of occupancy (June 2018 to June 2020) within the last five years. You would also qualify if you bought the house in 2018 and lived in it from June 2020 to June 2022. The two years of residency don’t need to fall in any particular place in the five-year ownership period.
It is important to note that you can only take the capital gains exemption for a sale once every 24 months. This can be an important part of your tax planning strategy if you own more than one property.
The Prorated Exclusion
If you did not use the property as your primary residence for at least 24 months, you may still be able to take a prorated exemption if you meet certain requirements. Eligibility includes a change of job location, a health issue, or an “unforeseen circumstance.” Examples of an unforeseen circumstance include (but are not limited to) death, divorce or separation, multiple births in the same pregnancy, or natural disaster.
The exemption is calculated by multiplying the percentage of time that you lived in the house by the amount of your exemption. For example, if you lived in the house for 12 out of 24 months and had to move for an eligible reason, you’d be able to use half of the exclusion.
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The Military Extension
In addition to the regular rules, there is a special rule for military members who are stationed away from the property. These members can “suspend” the five-year exemption timeframe for up to ten years. Therefore, if you otherwise qualify, you can take the capital gains exemption if you have lived in the house for two out of the last fifteen years.
For example, let’s say you bought a house in 2012 and lived in it until 2015. Then you received PCS orders to a location more than 50 miles away. You rented the house until 2020, when you sold it. You would still be eligible for the capital gains exclusion even though you did not meet the usual 2-out-of-5 rule, because you could suspend the time between 2015 and 2020.
There are a couple of things to note here:
- You can only suspend the five-year period for one property at a time.
- Your duty station must be more than 50 miles from the property or you must be ordered to live in government housing for any time suspended.
- Any suspended time must be while on active duty, but the entire calculation can extend into retirement.
Recaptured Depreciation
If your property has been a rental at any point, you will also need to account for the depreciation you’ve hopefully taken. The amount that you’ve depreciated goes into your overall capital gains calculation, but there’s no way to exclude that gain due to depreciation. So if you are selling a rental, you’ll owe an amount for the portion of the capital gain that is attributable to depreciation.
The way this is all laid out on the tax forms is not intuitive (at least to me.) You absolutely want a tax professional to assist you with this calculation.
Depreciation recapture is based on the amount of depreciation that was “allowed or allowable.” This means that even if you never depreciated your property, you’ll still be responsible to recapture that depreciation. If you find yourself in this situation, you may want to go back and file amended tax returns to get the benefit of that depreciation.
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Tax Planning
The way that these different rules work together can mean that when you sell your house may make a big difference in how much you’ll pay in taxes. If you own property, it is smart to plan ahead so that you’ll know exactly how decisions on timing will impact your tax liability. In some situations, even a few days can make a big difference in how much you’ll pay.
This post explains how capital gains exemptions work and how they may be impacted by military service. Now you are better prepared to work with your tax professional to see how these rules impact your specific details.
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