One of the best financial investments you can make is the house you live in or rent out. Between 1991 and 2022, the average annual U.S. home price increase was 4.3%, Credit Karma reported, citing data from the Federal Housing Finance Agency. Since 2000 the average increase has been 4.7%, and since 2012 the average rate has been 7.7%.
Given soaring home values over the last decade, it’s not uncommon for homeowners in 2023 to see hundreds of thousands of dollars in profit just by selling their homes. The downside is, you might get stuck with a big tax bill when you sell your home — especially if it’s an investment property instead of the house you live in.
The IRS and state tax agencies consider your home a capital asset, according to the Finance Buzz website. This means you might owe capital gains taxes on the profit from the home sale. Your profit is the positive difference between the sales price and purchase price you paid when you bought the home, plus adjustments such as closing costs and Realtor commissions.
There are ways to avoid these taxes, however. The one thing you need to keep in mind is that there are big differences between selling a home you live in vs. selling one that you either rent out or have held as an investment.
A home is considered your principal residence when you’ve lived in it for at least two of the past five years, Finance Buzz noted. In this case, you can exempt up to $250,000 in capital gains — or $500,000 for married couples filing jointly — from the sale of your home. If you made less than $250,000 from the sale, you won’t owe any taxes on it.
If you do have to pay capital gains taxes, they are broken down into short- and long-term taxes. Sorting through all this can be complicated, so you’ll want to contact a tax expert to help guide you through it. For more information, visit this IRS site.
In addition to ensuring that you meet the two-year requirement, here are some other ways you can avoid paying taxes from the sale of your home:
- Military relocation. If you’re a member of the U.S. military and are forced to move for a new assignment, you can get an exemption from the “two in five” requirement. To qualify, you must be relocated to a duty station at least 50 miles from your home or reside in government housing under government orders for more than 90 days or an indefinite period, according to Finance Buzz.
- 1031 exchange: Also known as a “like kind” exchange, this rule lets you exchange one investment property for another without recognizing the gain at the time of the exchange, according to Robin Sansone, a CPA and partner at Georgia-based Rhodes, Young, Black & Duncan. “However, you will want to work closely with your accountant to structure the exchange properly to avoid tax,” Sansone told the HomeLight website. For more information, consult the IRS’s Like-Kind Exchanges page.
- Research exceptions. If you don’t meet the “two in five” eligibility rule, you might qualify for an exception for reasons related to work, health, unforeseeable events and other circumstances. Refer to IRS Publication 523 to learn more.
Even if you can’t avoid taxes altogether, you can reduce them by deducting the cost of capital improvements. To qualify, the capital improvement must meet various criteria, according to HomeLight. These include increasing the value of the property, being permanently affixed to the property or serving as a permanent installation/improvement, such as an in-ground pool.
Another option is to make an installment sale in which you let the buyer break the purchase into installments over time. Doing so lets the seller spread out tax gains over multiple tax years, according to Finance Buzz. By breaking the sale into multiple payments over several years, you can reduce the tax impact.
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