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Real estate is a great investment, and selling your home could net you a hefty profit. However, that large profit can mean a big tax bill, which can reduce the amount you get to pocket from the sale. It may also dampen your plans to move to a new location.
Fortunately, there are critical moves you can do to reduce the taxes you owe when you sell your primary residence.
When you play it right using the IRS’s Home Sale Tax Exclusion, you can either partially or completely eliminate your tax bill, saving you tens of thousands (and sometimes hundreds of thousands) of dollars come sale time.
Whoa, right? Let’s dive in.
What Is A Primary Residence And Why Is It Important?
Before we get into the tax code, we do have to define the difference between a primary residence and property. According to the IRS, a primary (or principal) residence is the place where you spend the majority of the year, even if you don’t consider it your home.
For example, if you’re from Minnesota and have a home there, but spend eight months of the year in your summer home in Florida, your primary residence is your summer home, even if you are not legally a Florida resident.
This is important because the IRS offers specific benefits when you sell your primary residence. These same tax breaks and allowances won’t apply to your other property.
Most people will only own a single home, so this definition won’t matter – but it’s important to know nonetheless.
Reducing Taxes On The Sale Of Your Primary Residence
When it comes to the sale of a primary residence, the IRS allows:
- An individual to exclude up to $250,000 in profit from taxes
- Married couples to exclude up to $500,000 in profit from taxes
It’s important to note that this refers to only the profit from the sale.
For example, if you and a spouse bought a house for $400,000 and later sold it for $700,000, you wouldn’t have to pay any taxes on that $300K in profit.
Keep in mind that this exclusion works for any primary residence that you lived in for two years in the last five. This means that if you move to a new home and try to sell your primary residence in 2020, but aren’t able to do it until 2023, you’re still able to avoid taxes on the profit.
For obvious reasons, most people call this tax exclusion the “$250,000/$500,000 Home Sale Tax Exclusion.”
On the other hand, people who love technical jargon (like accountants), like to call it “Topic No. 701” because that’s its number in the IRS tax code.
Using A 1031 Exchange For Investment Properties
What if you have an investment property that you sell – are you completely out of luck? Fortunately, there is a way to avoid taxes!
A 1031 exchange lets you take the money you earn from selling an investment property and buy a completely new property, without having to pay taxes on the proceeds.
This can let you sell a smaller investment property and turn it into a newer or larger property. Keep in mind that a 1031 exchange will only work if you do not do anything else with the money you earn from the sale – it all has to go towards the purchase of a new property.
Then, you can move into your new property and turn it into your primary residence. It takes five years of you owning an investment property before it can be considered a primary residence. Of those five years, you’ll have to live there for at least two of those years for its status to change.
After five years, you’ll be able to sell the investment property and apply the IRS exception to your profits, cutting your tax bill down substantially.
What Taxes Will I Have To Pay?
While the above tips are a great way to avoid some taxes on the sale of real estate, they don’t cover everything. Of course, a successful real estate investment could easily net more than $250,000 (or $500,000, for married couples) in profit.
If this happens, or if you’re unable to claim your property as your primary residence, what can you expect to pay?
Real estate profits are classified as capital gains, so you’ll be subjected to capital gains taxes.
Fortunately, these are lower than income taxes, although they can still be substantial. For properties owned longer than one year, profits get taxed as a long-term capital gain.
If you’re a single filer that makes less than $39,375 a year, a married couple making less than $78,750 jointly, or a head of a household making less than $52,750, you will not have to pay any taxes on your capital gains (0% tax).
If you make between $39,376 to $434,550 as a single filer, you’ll pay a 15% tax. This also applies to married couples filing jointly that make between $78,751 to $488,850 combined, or heads of households making between $52,751 to $461,700.
The vast majority of taxpayers fall in this 15% tax bracket.
A 20% tax will apply to single filers making over $434,550, married couples making over $488,850, and heads of households making over $461,700.
These long-term capital gains tax rates are summarized below.
SINGLE FILERS:
| Long-term capital gains tax rate | Your income |
|---|---|
| 0% | $0 to $39,375 |
| 15% | $39,376 to $434,550 |
| 20% | $434,551 or more |
MARRIED FILERS:
| Long-term capital gains tax rate | Your income |
|---|---|
| 0% | $0 to $78,750 |
| 15% | $78,751 to $488,850 |
| 20% | $488,851 or more |
HEAD OF HOUSEHOLD FILERS:
| Long-term capital gains tax rate | Your income |
|---|---|
| 0% | $0 to $52,750 |
| 15% | $52,751 to $461,700 |
| 20% | $461,701 or more |
Reducing Your Tax Burden Lets You Achieve Your Financial Goals
Selling your primary residence can net you with a large profit that you can use to move into a larger and more comfortable home – or travel the world.
Making sure that you can keep as much of that profit as possible can help you achieve your financial goals, which is why it’s necessary for you to take steps to reduce the taxes you will owe.
It can be hard to keep up with the US tax code, which frequently changes from year to year. For more information about ways you can reduce your tax burden and improve your personal finances, check out this article on tax strategies.
What questions do you have about the primary residence tax exclusion? Ask them in the comments below and I’ll share thoughts.