If you’re planning to sell a house, you may have heard that you could be on the hook for paying capital gains tax. But what exactly is it? You see, when you sell real estate, the profit is referred to as capital gains. Capital gains tax is what is owed on the profit made from the sale.
There are two types of capital gains:
- Short-term – These are the profits realized from selling an asset you’ve had for as long as one year. These capital gains are taxed at a rate as typical income and typically range between 10% and 37%
- Long-term – These are profits that are realized from selling an asset that you’ve had for more than a year. The tax rate is almost always lower for long-term, typically between 0% and 20%, depending on your tax bracket. Because of this, it’s usually a better idea to hold onto your assets for a longer period.
1. Go for the primary residence exclusion
If you’re selling a home that’s been your main residence for a minimum of two of the past five years, as much as $250,000 of the capital gains can be excluded for a single person and as much as $500,000 of capital gains can be excluded for a married couple filing jointly. This is sometimes referred to as the 121 exclusion, which refers to the corresponding IRS regulation. Generally, you won’t be eligible for this exclusion if you excluded the gain from the sale of another home during the two-year period prior to selling your home. Refer to IRS Publication 523 for the complete eligibility requirements, limitations on the exclusion amount, and exceptions to the two-year rule.
For example, say Mr. and Mrs. Smith sold their home, which they had been in for five years, because they found their dream home and decided to exclude the gain. But then, Mr. Smith is transferred by his job to a different location, and now they have to sell their new home. In this scenario, they can’t exclude the gain.
2. Use the 1031 exchange
If an investment property is being sold and you’re planning to purchase another one, it’s possible to use this exchange (also known as a like-kind exchange) to defer paying the capital gains tax. However, the 1031 exchange has rules you’ll need to follow:
- Both properties must be real estate, rather than personal property.
- Both properties have to be located in the US.
- You have to identify your replacement property in 45 days and complete the exchange in 180 days.
- Sometimes there is a difference between the prices of the two properties. This is called ‘boot’. If this occurs, you may need to pay taxes on the difference. For instance, if you sell a property that is $500,000 and buy one that’s $350,000.
When it comes to determining who and what types of transactions are eligible for a like-kind exchange, take note that there are certain exclusions:
- Second homes
- Primary residences
- Partnership interests
Here’s an example of how a 1031 exchange could work: John’s investment rental property’s value went up, so he now wants to invest in a different property. In order to avoid paying capital gains taxes, he’ll conduct a 1031 exchange, and put the proceeds from selling his original property into buying the new property.
3. Utilize installment sales (seller financing)
Also called owner financing, this is a method in which the seller provides money to a buyer thanks to the equity in the property. The seller receives money each month until either the balance is due or the amount is completely paid off. This is beneficial to property owners because it provides them with a steady stream of income — plus, it has a few tax benefits.
Example: You sell a property for $500,000, and it’s structured in installments over a period of 10 years. The capital gains tax liability is spread over that amount of time. Each of the payments consists of interest, gain, and principal.
When you report the income from an installment sale, you use Form 6252. For instance, if you received 10 installment payments in 2025, you would put that on this form.
There are two main benefits of this strategy:
Tax Deferral: Rather than paying the full taxes for the sale, you only pay taxes as payments are received. This reduces the amount of taxes you pay immediately.
Tax Rates are Potentially Lower: When the gain is spread out over many years, you are able to stay in a reduced tax bracket. This can help reduce your tax liability overall.
4. Purchase in a qualified opportunity zones (QOZ)
Another option is to purchase a property in an opportunity zone. It’s a good choice for an investor who has capital gains and is looking to defer and possibly reduce tax liability. This is particularly true for those with a long-term horizon, as they can minimize their benefits when they hold it for 10 years. It can also be a great opportunity for real estate developers and investors who want to contribute to the development of a community.
Deferral Benefits Based on QOF Length of Time
When you hold your investment in a QOF, or Qualified Opportunity Fund, for a specific amount of time, you can enjoy significant benefits in correlation with capital gains.
| Minimum # of years QOF investment is held | Benefit |
|---|---|
| 5 years | 10% of deferred gain |
| 7 years | 15% of deferred gain |
| 10 years | Possibility to exclude the appreciation from exchanging or selling the investment from your taxable income. |
5. Convert a rental property to primary residence
If you want to avoid or minimize your tax obligation, you can convert a rental property into a primary residence, Keep in mind that you must live in the home for at least two out of the last five years before selling it in order to qualify for the home exclusion amount of $250,000 for single persons, and $500,000 for a married couple filing jointly.
Depending on your specific tax circumstances, you may also be able to deduct expenses for the time in which the property was either rented or used as a primary residence. Here’s how you might be able to calculate those amounts:
How to calculate the tax when converting
Here’s how tax is calculated when you’re converting a rental to a primary residence.
1. Calculate the adjusted basis
- Begin with your original property purchase price
- Subtract any claimed depreciation while the property was being used as a rental
- Add in the cost of capital improvements (these aren’t maintenance or repairs) made on the property
- Add in the selling costs (legal fees, repairs done prior to selling, realtor fees)
2. Figure out the total gain
This is figured out by subtracting the adjusted basis from your selling price.
3. Address your depreciation recapture
If there has been depreciation claimed during the property being used as a rental, it has to be recaptured. You then must report it as regular income. It’s taxed at the regular income tax rate, up to 25%.
4. Allocate the gain between the qualified & non-qualified use
For properties purchased after 2008, a special rule requires the proration of gain when the property was used for non-qualifying purposes (like a rental) before being used as your primary residence.
The gain exclusion amount is reduced pro rata based on the ratio of years used for non-qualifying purposes to the total years of ownership. For example, if you owned the property for 7 years and rented it for 2, then only 5/7ths of the gain qualifies for the Section 121 exclusion.
5. Apply the Section 121 exclusion
If you meet the ownership and use tests (owned and lived in the property as your primary residence for at least 2 out of the 5 years before selling), you may be able to exclude a portion of the remaining gain from taxation.
The exclusion is up to $250,000 for single filers and $500,000 for married couples filing jointly.
6. Calculate taxable gain
The remaining gain after accounting for depreciation recapture and the Section 121 exclusion will be taxed at your applicable capital gains tax rate.
6. Harvest tax losses in the same tax year
If you have other investments that have lost value and you do not intend to keep them, you can time the sale of these investments to be in the same tax year as the sale of a home. Selling investments at a loss can allow you to use the losses to offset any capital gains you have from the sale of the property.
As an example, if you hold stock in a company that you initially purchased at a net cost of $100,000, but the stock is now worth $20,000, you could sell your holdings in order to be able to claim losses of $80,000. Now let’s say you sell a property which incurs a capital gains amount of $200,000. While you’d ordinarily be required to pay taxes on the $200,000, selling your stock holdings would effectively reduce your tax bill by $80,000, so you’d only be taxed on $120,000 in capital gains.
If you decide to go this route, I recommend consulting an accountant or tax expert first to ensure that your sale of investments would allow you to offset your capital gains from real estate in the manner described above, as tax rules and regulations can be complex and highly dependent on your specific set of circumstances.
7. Sell the property in a different year
Your capital gains tax rate is based on how long you’ve held it and what your taxable income bracket is. Since your taxable income bracket can range from 0% to 37% (for short- and long-term capital gains rates), choosing to sell the property in a lower income year can allow you to pay taxes based on a smaller tax bracket, even if the home value remains the same.
8. Write off improvements that were made to the home
If you made improvements to the home prior to selling it, it’s possible that you could adjust your initial cost basis, which is something that could reduce your capital gains liability upon the sale of the property. For example, if you bought a home for $500,000 and subsequently installed a new roof and HVAC system for a total added cost of $100,000, your adjusted basis could become $600,000. If you later sell the property for $800,000, you’d only be responsible for capital gains tax on $200,000 rather than $300,000.
Not all improvements made to your home can be added to your property’s initial cost basis. Generally, it must be something that materially adds value or significantly prolongs its lifespan. Home improvements that are likely to qualify include:
- Addition of new rooms
- Replacement of insulation and plumbing
- Installation of a new roof or windows
- Replacement or improvements to walkways and driveways
- Installation of new fences or retaining walls
- Installation of new appliances and carpeting
Common mistakes to avoid to minimize costs
When it comes to capital gain taxes, there are some things that you should avoid doing because they can cost you money.
- Selling too quickly – A very common mistake that people make is selling their assets too quickly. When selling a home within a year of purchasing it, any profits you earn will be considered short-term gains, and you’ll pay a higher amount in income taxes. It’s best to own and live in the house for at least two out of five years to put you in the long-term capital gains tax rates.
- Forgetting about state taxes – Even though the long-term capital gains get taxed at a federal level, a lot of states impose them on a state level as well. There are states that have rates similar to regular income taxes. This can negatively impact your tax amount. When you don’t consider these taxes, you may find yourself in a poor financial position.
- Not considering the best course of action – Some strategies of deferral won’t work for everyone. So, you want to think about what will work best for you.
Frequently asked questions (FAQs)
Can I deduct a loss when selling my home?
It depends. There are some losses that you can deduct. These include:
- losses on the property used in a business or trade
- losses due to a transaction that was entered into to make a profit
- Certain qualifying casualty losses.
How are sales from second homes reported?
A second residence, like your vacation home, would be called your capital asset. Forms 1040 and 8949 are used for reporting exchanges and sales.
Do I have to pay taxes if I lost money on the sale of a home?
Yes — and generally you can only do so if the home was an investment property. If the loss occurred on a primary residence, you will be unable to treat it as a capital loss when you file your tax returns.
Bringing it all together
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