facebook twitter instagram linkedin google youtube vimeo tumblr yelp rss email podcast phone blog search brokercheck brokercheck Play Pause
Will You Owe Taxes When You Sell Your Home in Retirement? Thumbnail

Will You Owe Taxes When You Sell Your Home in Retirement?

Tax Planning

Selling your longtime home in retirement and moving someplace new can be an exciting yet challenging transition. As you prepare for this major life change, your mind may fill with questions about what the process will entail. One common concern retirees have is whether they'll owe any taxes when they sell their home.

This is an understandable worry. After all, your home is likely your largest asset and most retirees depend heavily on fixed incomes. Having to fork over a chunk of your home sale proceeds to taxes could throw a wrench in your retirement plans.

The good news is you may be able to exclude a substantial amount, or even all, of your home sale profit from capital gains taxes. With proper planning and an understanding of the rules, you can minimize surprises and taxes when you sell your house in retirement.

Let's dive in!

KEY TAKEAWAYS

  • You may qualify to exclude up to $250,000 (single filers) or $500,000 (joint filers) of capital gains when selling your principal residence if you meet certain IRS criteria.
  • Track your home's cost basis and any adjustments over the years. This is vital for accurately calculating capital gains.
  • Special rules apply for divorce and military service cases regarding the ownership and use tests.
  • You must report the sale to the IRS if you have a taxable capital gain or receive Form 1099-S.
  • Strategies like capital loss offsets and home improvements can help lower or avoid owing capital gains taxes.
  • Inheriting a home means your basis becomes the fair market value on the previous owner's date of death rather than their original cost basis.
  • Consult a trusted tax or financial advisor when planning to sell your longtime home.

OVERVIEW OF CAPITAL GAINS TAXES ON HOME SALES

When you sell your home at a profit, meaning for more than you originally paid for it and invested in improvements, the difference is considered a capital gain. Capital gains from selling assets like stocks, bonds, precious metals, antiques, and real estate may be subject to capital gains taxes.

Homes are treated as capital assets by the IRS. So when you sell your principal residence for more than your adjusted cost basis (the amount paid to purchase the home plus improvements), you may have to pay capital gains taxes on the profits, also called the capital gain.

However, thanks to the Taxpayer Relief Act of 1997, most homeowners can exempt a large portion of their home sale profit from capital gains taxes.

Tax Exclusion Limits

Single sellers can exclude up to $250,000 of capital gain, and married couples filing jointly can exclude up to $500,000 when they sell their primary residence. This applies if you meet certain IRS qualifications outlined below.

Any home sale profits above your exclusion will be subject to capital gains tax rates, which range from 0% to 20% for most taxpayers depending on your total income and filing status.

Eligibility for Exclusion

To qualify for the home sale capital gains exclusion, the home must be your principal residence. The IRS defines this as the primary location where you live.

You also must meet both the ownership and use tests:

  • Ownership - You must have owned the home for at least 2 out of the previous 5 years before selling.
  • Use - You must have lived in the home as your primary residence for at least 2 out of the previous 5 years before selling.

The 24 months of ownership and use do not have to be consecutive. You also cannot have claimed the capital gains home sale exclusion for another home you sold within the previous 2 years.

These requirements aim to prevent taxpayers from buying homes, living in them briefly, then selling them just to take advantage of the tax break.

WHEN HOME SALE PROFITS ARE FULLY TAXABLE

Gains from a home sale are fully taxable, without the exclusion, when:

  • The home is not the seller's principal residence
  • The home was acquired through a 1031 exchange within 5 years
  • The seller is subject to expatriate taxes
  • The seller did not meet the ownership and use tests
  • The seller claimed the exclusion on another home sale within 2 years

Next, let's look at how to calculate whether you have any taxable capital gains when you sell your home.

CALCULATING CAPITAL GAINS ON A HOME SALE

Figuring out if you'll owe any taxes when selling your longtime home isn't too complicated with some basic math. Here are the steps:

  1. Determine your home's sale price - This is the amount another buyer pays to purchase your home.
  2. Calculate your adjusted cost basis - This includes:
    • Original purchase price
    • Improvements and additions
    • Certain closing costs and fees (More details on determining basis below)
  3. Subtract your adjusted cost basis from the sale price - This gives you your capital gain amount
  4. Subtract your capital gains tax exclusion - For single sellers, exclude up to $250,000 of gain. For married joint filers, exclude up to $500,000.
  5. The remainder is your taxable capital gain - You'll owe capital gains taxes on this amount if greater than zero.

For example:

  • John and Jane purchased their home for $200,000.
  • Over the years, they added a pool for $10,000 and remodeled their kitchen for $15,000.
  • They sold their home for $400,000.
  • Their adjusted cost basis is $200,000 + $10,000 + $15,000 = $225,000
  • Sale price of $400,000 - adjusted basis of $225,000 = capital gain of $175,000
  • As married joint filers, they can exclude the first $500,000 of the gain.
  • Therefore, John and Jane owe no capital gains taxes on the sale.

Now let's go over some special situations that may impact your eligibility for the home sale capital gains exclusion.

SPECIAL SITUATION FOR HOME SELLERS

If you're divorced or have been relocated for military service, special rules may apply when determining if you qualify for the home sale capital gains tax exclusion.

Divorce

For divorce cases, the spouse who retains ownership of the home can count any time the home was owned by the former spouse to meet the 2 out of 5 years ownership requirement.

Additionally, the time a former spouse lives in the home until the sale date counts toward the use test for the spouse granted ownership.

Military Personnel

For members of the military and certain government officials on extended duty, the ownership and use tests can be suspended for up to 10 years during service.

This means as long as you lived in the home for at least 2 of the previous 15 years before selling, you can qualify for the exclusion. The same applies to a spouse who shared ownership.

Non-Military Government Service

For non-military government personnel, such as members of the Foreign Service or intelligence community, the 5-year test period may be suspended for up to 10 years for service abroad.

The time living in the home during an extended leave prior to the sale also counts as time lived in the property.

REPORTING THE SALE OF YOUR HOME

You must report your home sale to the IRS if:

  • You do not qualify for the full capital gains exclusion
  • You received Form 1099-S reporting proceeds from the sale
  • You choose to report the sale even if you qualify for the full exclusion

Form 1099-S is used by real estate agencies, closing companies, and mortgage lenders to report the sale of real estate to the IRS.

You'll receive Form 1099-S if the sale price exceeds certain thresholds:

  • $250,000 for single sellers
  • $500,000 for married couples filing jointly

And you do not provide certification to your real estate provider that you qualify for the full capital gains exclusion.

If you qualify to exclude the entire gain and thus won't owe any capital gains taxes, inform your real estate professional by February 15 of the following year so you do not receive Form 1099-S.

AVOIDING CAPITAL GAINS TAXES ON THE SALE OF YOUR HOME

Now that you understand the basics of home sale capital gains taxes, how can you avoid or minimize them? Here are some key tax planning strategies:

  • Use capital losses to offset gains - If you realize losses on the sale of other investments, use them to offset your home sale capital gains. You can deduct up to $3,000 of capital losses per year from your income taxes or carry losses forward.
  • Lower your taxable gain with home improvements - Increase your home's cost basis by adding the cost of home improvements. This lowers your capital gain.
  • Live in the home 2 of the past 5 years - Meet the ownership and use tests to qualify for the IRS capital gains exclusion.
  • Wait at least 2 years between sales - You can't claim the capital gains home sale exclusion if you already used it for another home sale less than 2 years ago.
  • Consider a 1031 exchange - With an investment property, you may defer capital gains by exchanging it for another like-kind rental or investment property. You must complete the exchange within 180 days.
  • Convert a second home or rental to your primary residence - You can convert a second home or rental property to your principal residence for 2 years before selling to qualify for the capital gains exclusion.
  • Use an installment sale - Spread your capital gains over several years through a series of payments ("installments") rather than receiving a lump sum. This can lower your annual taxes.

Thoroughly understand your options, and consult a trusted tax or financial advisor when planning a home sale.

INHERITING AND SELLING A HOME FROM A PARENT OR RELATIVE

If you inherit a home from a deceased parent or other family member, different rules apply when it comes to capital gains taxes if you choose to sell the property.

In this case, you do not inherit the original owner's cost basis. Instead, your basis becomes the fair market value of the home as of the previous owner's date of death. This is what’s called step-up in basis.

Example:

  • Your mother purchased her home for $100,000 in 1990.
  • At the time of her passing in 2020, the home was worth $250,000. This becomes your basis.
  • You sell the inherited house in 2022 for $250,000.
  • Your capital gain is $250,000 (sale price) - $250,000 (basis) = $0.

When you inherit a home, consult a tax professional to ensure you properly determine basis and capital gains.

HOW TO DETERMINE YOUR HOME'S COST BASIS

Your home's cost basis forms the foundation for calculating capital gains. It includes:

  • Original purchase price
  • Purchase costs - inspections, closing fees, etc.
  • Improvements and additions
  • Certain legal fees

You need evidence like receipts, bank statements, or settlement sheets to prove your original basis and any subsequent adjustments. Keep these records on hand before selling.

Basis increases with things like:

  • Room additions
  • Remodels like kitchens and bathrooms
  • Upgraded systems - electrical, plumbing, HVAC
  • Outdoor additions like decks, patios, pools

Basis decreases due to events like:

  • Insurance reimbursements you receive for casualty losses
  • Post-purchase price reductions

Check with a tax pro to confirm which adjustments impact your basis and by how much.

FREQUENTLY ASKED QUESTIONS ON CAPITAL GAINS AND HOME SALES

Below are answers to some common questions retirees may have about how capital gains taxes work when selling a home:

How much is capital gains tax on a home sale?

If your capital gains from selling your principal residence exceed the IRS exclusion limits ($250,000 for singles, $500,000 for married joint filers), any amount over those limits is subject to capital gains tax rates.

These rates range from 0% to 20% depending on your total income and tax filing status. For 2023 taxes, the rates are:

  • 0% - Single filers with income under $44,625 or joint filers with income under $89,250
  • 15% - Single filers with income $44,626 to $492,300 or joint filers with income $89,251 to $553,850
  • 20% - Single filers with income over $492,300 or joint filers with income over $553,850

Do you pay capital gains tax when selling a second home?

Generally yes, since the IRS capital gains home sale exclusion applies only to your principal residence. However, you may convert a second home into your primary residence by living there for 2 of the past 5 years before selling.

This involves being able to prove you spent enough time in one home to qualify it as your new main residence. If you convert a second home, capital gains during the rental period may still be taxed.

How can I avoid capital gains tax when selling my home?

Strategies to avoid owing capital gains taxes include:

  • Using capital losses from other investments to offset home sale gains
  • Lowering your gain with home improvements to increase cost basis
  • Living in the home for 2 of the past 5 years to qualify for the IRS exclusion
  • Waiting at least 2 years if you already claimed the exclusion on another property
  • Attempting a 1031 exchange by reinvesting in a similar rental or investment property
  • Converting another property like a rental or second home into your primary residence

Do I have to report the sale of my home to the IRS?

You must report the sale of your home to the IRS if:

  • You have a capital gain that exceeds the IRS exclusion limits
  • You receive Form 1099-S reporting the sale
  • You choose to report the sale even if you qualify for the full exclusion

If you qualify to exclude the entire capital gain and won't owe any taxes, inform your real estate professional by February 15 of the following year so you do not receive a 1099-S form.

CONCLUSION

Selling a home, especially later in life, can be filled with emotion and logistical challenges. Ensure taxes don't give you an additional headache by understanding capital gains exclusion rules. With the right planning, you can minimize or completely avoid owing taxes on your home sale profit.

👉 If you would like to get a FREE retirement assessment, click the link to schedule your 20-minute call to start the retirement assessment process.