When selling a primary residence, homeowners often ponder the implications of capital gains tax on their profits. If a homeowner sells their property and realizes a profit of $1 million, they may face a significant tax bill. The amount of tax owed can range from tens of thousands to a hundred thousand or more, depending on various factors. One of the most significant factors is your income.
Homeowners need to understand the components of this tax calculation and consider consulting a financial adviser for guidance on managing potential tax liabilities.
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The IRS treats the sale of a home as a capital gain or loss, similar to other types of investments. If the property was owned for more than a year, capital gains rates apply, while properties held for less than a year are taxed at earned income rates.
Taxes are only levied on the profit from the sale. This profit is calculated by deducting the adjusted cost basis of the home from its sale price. The adjusted cost basis includes the initial purchase price, value-added through interior remodeling like kitchen renovations, internal updates such as new windows or furnace improvements, external additions like adding a room, and certain legal, agent and sales fees. Routine repairs and mortgage interest payments do not increase the home’s adjusted basis.
To determine the capital gain, subtract the property’s adjusted cost basis from its sale price. It’s important to note that not all of this gain is necessarily subject to tax.
The IRS offers significant exemptions for the sale of primary residences. Married couples can exclude up to $500,000 in profits from capital gains tax, while single taxpayers can exclude up to $250,000. This exemption, known as the Section 121 exclusion, requires the homeowner to have owned and used the property as their primary residence for at least two of the past five years. These two years of residency need not be consecutive.
To qualify for this exclusion, the homeowner must not have claimed a Section 121 exclusion on another property within the previous two years. In certain circumstances, the IRS may grant a partial exclusion even if the standard criteria are not met, but such exceptions are situational and require specific requests to the IRS.
Consider a scenario where a homeowner sells their primary residence for $1 million, having originally purchased it for $225,000 in 2009. This situation presents a significant potential for capital gains tax. The calculation would involve deducting the adjusted cost basis (the original purchase price, plus any qualifying improvements) from the sale price to determine the taxable gain.
Example Calculation
Original purchase price in 2009: $225,000
Improvements and qualifying additions: Assume $75,000 for a kitchen remodel or new windows
Sale price in 2023: $1 million
Adjusted cost basis: $225,000 + $75,000 = $300,000
Capital Gain: $1,000,000 – $300,000 = $700,000
Income: $250,000 annually
Tax Implications
For a single homeowner, the first $250,000 of this gain would be exempt under Section 121 exclusion. For a married couple, up to $500,000 of the gain could be exempt.
A single homeowner would potentially face capital gains tax on $450,000 ($700,000 – $250,000), while a married couple might be taxed on $200,000 ($700,000 – $500,000).
If a couple’s income is $250,000, they are placed in the 15% federal tax bracket for long-term capital gains in 2023.
15% of $200,000 = $30,000 owed.
Ownership and use test: To qualify for the Section 121 exclusion, the homeowner must have used the home as their primary residence for at least two of the five years preceding the sale.
Previous exclusions: If the homeowner has already claimed a Section 121 exclusion on another property in the last two years, they may not be eligible for the full exemption.
Market factors: The real estate market’s condition at the time of sale can significantly impact the sale price and the capital gain.
Improvement documentation: Homeowners should maintain detailed records of all home improvements and additions, as these can substantially affect the adjusted cost basis and, consequently, the capital gains tax liability.
Income: In 2023, single filers with an income below $44,625 and married couples earning up to $89,250 fall into the 0% capital gains tax bracket when selling a home. In 2024, these limits increase to $47,025 for single filers and $94,050 for married couples.
The rate of capital gains tax and its payment timeline vary depending on several factors.
Capital Gains Tax Rate
Long-term capital gains: For assets held more than a year (like a primary residence), the tax rate varies based on the taxpayer’s income. As of 2023, long-term capital gains tax rates are typically 0%, 15% or 20%. Given the complexity of these calculations and the potential for significant tax implications, seeking advice from a financial adviser or tax professional is advisable.
Income brackets: The specific rate depends on the taxpayer’s filing status and taxable income. For example, people with higher incomes may be subject to the 20% rate, while those with lower or moderate incomes might pay 0% or 15%.
Net investment income tax: Additionally, people with high incomes may also be subject to an additional 3.8% tax on net investment income, including capital gains, under certain conditions.
When Capital Gains Tax Is Due
Capital gains tax is paid in the year the property is sold.
Taxpayers must report the sale and any capital gain on their income tax return for that year.
If a large capital gain is expected, taxpayers may need to make estimated tax payments throughout the year to avoid penalties.
Payment Process
Taxpayers report capital gains on Form 1040, Schedule D and Form 8949.
Payment can be made through estimated tax payments or when filing the annual tax return.
It’s advisable to consult with a tax professional to ensure accurate reporting and payment.
State Taxes
In addition to federal taxes, some states also levy a tax on capital gains. State tax rates and rules vary, so it’s important to be aware of the specific regulations in the state where the property is located.
Capital gains tax rates vary based on income, and the tax is due in the year of the property sale. Calculating capital gains tax requires determining the gain, applying exemptions and then applying the appropriate tax rate. Given the complexity and potential impact on personal finances, consulting with a tax professional and financial adviser is recommended for accurate assessment and compliance.
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