As we enter peak real estate season, here are two ways homeowners can reduce or eliminate capital gains when selling their home:
- Qualify for the Section 121 exclusion by meeting the ownership and usage tests
- Increase the basis of your home by documenting home improvement spending
My Personal Example
In 2008 we sold our first home after owning it for just over two years for a gain of $11,000. No tax problem.
In 2015 we sold our second home after owning it for six years for a gain of $5,000. No tax problem.
In 2022 we sold our third home after owning it for six years for a gain of $607,000. Houston, we have a tax problem.
Before the pandemic, I would have NEVER dreamed that I would sell a home for a gain of $600K+. We were historically lucky to be in a hot market (Seattle) at the right time, but we also faced the tax consequence of that luck. Just like selling appreciated stock, the gains from real estate transactions can be subject to capital gains tax.
Luckily, there were two tactics we used to reduce our tax liability to $0. First, we fully qualified for the home sale capital gains exclusion (Sect 121) by meeting the following criteria:
- We had owned and used our home as our primary residence for at least two of the last five years.
- We had not excluded the gain on another home during the two-year period prior to the sale.
Since our tax filing status was Married Filing Jointly, we could exclude $500,000 of capital gains. If you don’t file a joint return with a spouse you can qualify to exclude up to $250,000.
OK, $500,000 of gains down, $107,000 to go.
A second way you can decrease gains is to increase the basis in your home via the costs of capital improvements, as well as certain transaction fees you pay in purchasing and selling. Increasing your basis directly decreases your gain. There is plenty of nuance on what counts as a capital improvement vs. a repair, so talk to a tax or financial professional, but in my case I was able to increase my basis by more than $107,000, fully eliminating the remaining capital gains tax liability. The key is being able to document your capital investments in the home with receipts. Remodeling a kitchen or bathroom? Upgrading your windows or doors? Expanding your deck? Save those receipts.
One last note. Selling a home for a gain exceeding the exclusion amount used to be a problem reserved for the rich and famous. However, a homeowner’s chance of exceeding the capital gains exclusion threshold is increasing. Since the pandemic, the median sales price of houses has increased 28% (Q1 2020 – Q1 2024, FRED St. Louis). However, the exclusion amounts ($500K/$250K) have not budged since they were instituted in 1997. Unlike many thresholds in the tax code, the home sale capital gain exclusion does not adjust with inflation. As home prices continue to rise, exceeding the exclusion threshold is going to happen more and more.
Save those home improvement receipts. You never know when good luck will strike.
If you have tax planning questions, let’s talk.
This information is for educational purposes only and should not be construed as personalized financial advice; individuals should consult with a qualified professional for their specific financial needs and circumstances.
