Have you thought of selling your home and wonder if you'll owe long-term capital gains tax? After the rapid rise in home prices, owners worry their home appreciation has exceeded the limits of the primary residence tax exclusion.
by Scott A Jacobs
I've had questions and comments so frequently with the surge in valuations over the past few years that I thought I would write about it this month - mainly to show that most of us will not have to worry about capital gain. If you do have a large gain, how you can limit your exposure with this section of the IRS tax code?
To qualify for the Capital Gains federal exemption in the tax code, you must own and occupy your property as your principal residence for at least 2 of the last 5 years. At the federal, state and city level this allows you to avoid paying capital gains tax on the first $250,000 for single-filers and $500,000 for married couples filing jointly. The exemption can only apply to your principal residence once every two years and only to long-term gains (owned 12 months or longer). There are also Medicare and state tax considerations to be aware of that we’ll cover later in this article.
The Long-term Capital Gains tax rate is determined by your filing status and taxable income level (see table below). The rate is multiplied by the realized gain in your home’s value that is above the federal exemption level.
So, what determines your realized gain and how is it calculated?
The most basic calculation to determine the realized gain on your home is to simply subtract the sale price from your purchase price (aka your cost basis). The difference is your realized capital gain. The good news is that there is a way to reduce this gain to avoid taxes.
Let’s take a look at a married couple filing jointly who are selling the home they purchased for $300,000 many years ago.
Example #1
(Sales price) - (Purchase price) = (Capital gains)
($800,000) - ($300,000) = ($500,000)
No capital gains tax since it’s equal to or less than the $500,000 exemption.
= No tax is due.
Example #2
(Sales price) - (Purchase price) = (Capital gains)
($875,000) - ($300,000) = ($575,000)
= Tax is due on $75,000 that exceeds the federal exemption of $500,000.
So how can you can reduce your realized gain by raising your cost basis and by documenting the expenses to sell your home?
This is where good record keeping and a knowledgeable accountant come in.
You can add the purchase expenses to your cost basis from when you bought the home such as: closing costs, title insurance, real estate commissions, attorney fees, settlement fees, and transfer taxes.
You can also add the costs of any improvements to your cost basis that you have made to the home that have a useful life of greater than one-year such as: room additions, a new kitchen, finishing the basement, new appliances, landscaping, a new roof, flooring, replacement windows, new deck, patio and new or replacement mechanicals, etc.
And you can also add to your cost basis the cost of selling your home such as real estate commissions, closing costs, staging, painting, landscaping, photography, and advertising.
But you cannot add to your cost basis the costs of any improvements that you have made to the home if it’s considered general maintenance, decorative or is no longer part of your home.
By the time you finish totaling the costs of buying, selling, and improving the property, your capital gain on the sale will be lower – and for most, will likely be enough to qualify for a partial or full exemption.
Let’s look at the married couple example from above that now has added a $20,000 bathroom with the receipts to verify the cost:
Example #2b
(Sales price) - (Purchase price + improvements) = (Capital gains)
($875,000) - ($320,000) = ($555,000)
= Tax is due on the $55,000 that exceeds the federal exemption of $500,000.
Now let’s take look at the same married couple filing jointly that added that $20,000 bathroom, and where their accountant also reminded them to provide the closing documents from the purchase of their home where they incurred $10,000 in closing costs:
Example #2c
(Sales price) - (Purchase price + improvements + closing costs) = (Capital gains)
($875,000) - ($330,000) = ($545,000)
= Tax is due on the $45,000 that exceeds the federal exemption of $500,000.
As you can see, by raising the cost basis of your home, it may help you with avoiding unnecessary taxation. And due to the large exemption, fortunately most home sellers won’t have to worry about paying capital gains tax at all.
But for the few of you that have owned your home for many years and have seen incredibly high valuation increases, keeping receipts in a home improvement file in the event you may have to reduce your gains, will pay off when you do sell your home.
2023 Federal Rate:
Long-term capital gains tax rates beyond the federal exemption for the 2023 tax year:
Individual filers with taxable income of...
$44,625 or less = 0%
$44,626 to $492,300 = 15%
$492,301 or higher = 20%
Married filing jointly with taxable income of...
$89,250 or less = 0%
$89,251 to $553,850 = 15%
$553,850 or higher = 20%
2023 Medicare Rate:
Adds a surtax of 3.8% on the lesser of (1) net investment income or (2) the excess of modified adjusted gross income over a set threshold amount.
Individual filers with taxable income of...
$200,000 = an additional 3.8% on top of the federal rate
Married filing jointly with taxable income of...
$250,000 = an additional 3.8% on top of the federal rate
2023 State of Michigan Rate:
The Michigan Department of Treasury treats capital gains as individual income. And due to the IRS rule requiring “the person responsible for closing the transaction” being required to file form 1099-s, reporting the proceeds from a real estate transaction, a capital gain on the sale of a Michigan home will be included in your Michigan taxable income, and taxed at the individual tax rate of 4.05%.
As you can see, the combined 2023 long-term capital gains tax rate may be anywhere between 0% and 27.85%.
There are many strategies beyond this limited information that are available to reduce your tax liability. Always check with your tax advisor and/or attorney for your specific situation.
by Scott A Jacobs