Selling a home can be a stressful, time-consuming process. And if you manage to come away with a profit, you may be worried that the IRS will swoop in and take some of your money. If you're wondering whether you'll pay tax when you sell your home, the quick answer is maybe, but probably not.
Capital gains taxes on your home
When you sell an investment at a profit, you're typically required to pay a capital gains tax. While the IRS makes a distinction between long-term and short-term capital gains, generally speaking, when you earn money by selling a stock or bond for a price that's higher than what you paid for it, you're obligated to hand over a portion of your profit to taxes.
Home sales, however, work differently. In fact, you may be able to sell your home for a significant profit without having to fork over a dime in taxes to the IRS. If you're a single tax filer, your first $250,000 of profit on a home sale is exempt from capital gains taxes. If you're a couple filing jointly, you can exclude up to $500,000 in profit from the sale of your home.
Now this wasn't always the case. Prior to May of 1997, the only way to avoid capital gains taxes on the sale of a home was to use the money to buy another home within two years. Sellers who were 55 and older had an additional option -- they could take a one-time tax exemption of up to $125,000. But following the Taxpayer Relief Act of 1997, those rules were replaced with the current ones, which not only allow you to exempt either $250,000 or $500,000 in capital gains, but also don't require that you filter that profit into another home.
Of course, there are some rules at play. To be eligible for the current exemption, your home must be your principal residence, and you'll need to have owned and lived in your home for at least two of the five years prior to the sale. Furthermore, you won't be eligible for the exemption if you already claimed a home-sale exclusion on your tax returns during the previous two-year period. But as long as you meet these criteria, you can walk away with a huge chunk of cash from selling your home and use it as you see fit.
Lowering your taxes when gains are high
So what happens if you really make a killing on your home and your profit exceeds the current exemption limits? Thankfully, you're not necessarily doomed to pay taxes provided you put some money into improving your home over the years. Any money you spend to increase the value of your home gets added to your property's cost basis, and the higher your cost basis, the lower your profit will be when you sell at a gain. All you need to do is retain proof in the form of receipts, work orders, or any other documentation detailing the project at hand as well as its costs.
For example, let's say you're a single tax filer who bought a home for $200,000 and sold it for $500,000. That's a $300,000 gain, which means you'd normally be liable to pay taxes on $50,000 of that profit. However, if you spent $50,000 on an addition to your home several years back, you can add that amount to the cost of your home for a total of $250,000, thus knocking your profit down to $250,000 and sheltering you from taxes.
Now keep in mind that this provision applies to home improvements only. If you build a sunroom, add a deck, or have a pool put in, you can add it to your home's cost basis. But if you spend money to repair a leaky roof or faulty furnace, you can't add that cost to your home's basis. Rather, that's just an unfortunate but common cost of homeownership.
While it's hard to avoid taxes on most investments, if you play your cards right, you may come away from the sale of your home free and clear of taxes. And no matter where you're headed in life once you sell, that's something to celebrate.