IRS Section 121 allows a reduction of potential capital gains taxes by $250,000 for single filers and $500,000 for married filing jointly filers when certain tests are met for the sale of your primary residence.
Simply put – If you have a capital gain from the sale of your main home, you may qualify to exclude up to $250,000 of that gain from your income for single filers, or up to $500,000 of that gain if you are married and file a joint return with your spouse.
See below discussions on the two part “test” for qualification, examples and more information.
These rules have been in place since 1997. Prior to 1997, different rules applied that let homeowners avoid capital gains taxes by rolling their profits into another home, as long as the purchase price of the new house was equal to or greater than the home they sold. Those are long gone and replaced by the new $250,000 / $500,000 exclusions, regardless if you buy a new home or not. See below for some notes on potential taxes due if you rolled over prior to 1997 and are now seeking to sell that home.
How To Qualify For The $250,000 or $500,000 Exclusions: Two Part Test
There are TWO tests for qualification; you must pass both tests…. “the ownership test” and “the use test”….
– “The Ownership Test”: If you owned the home for at least 24 months (2 years) out of the last 5 years leading up to the date of sale (date of the closing), you meet the ownership requirement. For a married couple filing jointly, only one spouse has to meet the ownership requirement.
– “The Use Test” / Residency: If you owned the home and used it as your residence for at least 24 months of the previous 5 years, you meet the residence requirement. Note: The 24 months of residence can fall anywhere within the 5-year period, and it doesn’t have to be a single block of time. All that is required is a total of 24 months (730 days) of residence during the 5-year period. However, if you used the property as a rental for that time, you still may have depreciation recapture considerations. Unlike the ownership requirement, each spouse must meet the residence requirement individually for a married couple filing jointly to get the full exclusion.
If you meet these tests, great, you can exclude $250,000 (single) or $500,000 (married filing jointly) from the gain of your sale.
There are, of course, exceptions, such as: time away from the home while in service such as military / armed services, intelligence or Peace Corps; a separation or divorce; the death of a spouse; the sale of vacant land; homes that were destroyed or condemned; and others that simply cannot be covered here. Refer to IRS Publication 523 for the complete eligibility requirements, limitations on the exclusion amount, and exceptions to the two-year rule, citations below.
What Does That Mean?/ What are Capital Gains Taxes?
Generally speaking, any ‘profit’ on the sale of your primary residence (i.e. the difference between what you paid for it, and what you sell it for, less expenses and other allowable deductions) will be taxed as “capital gains.”
Capital Gains Taxes are simply another tax. Even though the money you used to purchase the property and make the mortgage payments were already taxed, there are additional taxes now due at the time of sale, called “capital gains.”
So, if you purchased your home for $100,000 and sold it many years later for $1,000,000, you essentially have $900,000 in “capital gains” on that sale.
The IRS Section 121 exclusions are significant potential savings; but, if your profit is well over those allowances, you will still owe capital gains taxes, potentially significant amounts. This fear of taxation is one of the many factors contributing to our tight housing supply, i.e. people do not want to sell knowing they will have to pay capital gains taxes on their profits, even if they buy a new home.
What are Capital Gains Tax Rates?
Long-term capital gains tax rates for the 2022 tax year are as follows:
(note – IRS capital gains rates are based on your total income for the year, including the capital gain, but only the capital gain is then subject to the below rate, your other income will be subject to different / ‘regular’ rules):
- Up to $41,675 – 0% capital gains tax rate
- $41,676 – $459,750 – 15% capital gains tax rate
- Over $459,750 – 20% capital gains tax rate
Married Filing Jointly:
- Up to $83,350 – 0% capital gains tax rate
- $83,351 – $517,200 – 15% capital gains tax rate
- Over $517,200 – 20% capital gains tax rate
Married Filing Separately:
- Up to $41,675 – 0% capital gains tax rate
- $41,676 – $258,600 – 15% capital gains tax rate
- Over $258,600 – 20% capital gains tax rate
Head of Household:
- Up to $55,800 – 0% capital gains tax rate
- $55,801 – $488,500 – 15% capital gains tax rate
- Over $488,500 – 20% capital gains tax rate
Thus the highest federal capital gains rate is currently 20%.
On top of that, The Affordable Care Act, aka “Obamacare” imposed a Medicare Tax on long term capital gains for high income earners, those with adjusted gross incomes over $200,000 for individuals and $250,000 for married couples of an additional 3.8%.
Additionally, California (and some other states) will want their tax too! California will treat the capital gains as ordinary income for tax purposes (i.e. it just gets added on top of whatever else you make, and the total amount is treated as your taxable income). The greater the amount, the greater the risk of being pushed into California’s highest tax bracket of 13.3%.
Therefore, the worst case, for high profits (or high earners) in California, capital gains taxes are up to 37.1%. That’s over a full one-third of the gain, out the window, in taxes.
What Else Can I Deduct To Reduce My Capitals Gains Exposure: Improvements and Expenses
You can further reduce that amount by excluding certain expenses and other allowable deductions, such as capital improvements to the home, if any, and selling expenses such as REALTOR fees, escrow and title fees and the like.
“Improvements” generally add to the value of your home, prolong its useful life, or adapt it to new uses, such as room additions and modernization like kitchen or bathroom remodels or electrical upgrades.
Here are some specific examples from the IRS of what DOES count as improvements:
- Additions to Bedroom, Bathroom, Deck, Garage, Porch or Patio
- Lawn & Grounds such as Landscaping, Driveway, Walkway, Fence, Retaining wall and Swimming pool
- Systems such as Heating system, Central air conditioning, i.e. HVAC, Furnace, Duct work, Central humidifier, Central vacuum, Air/water filtration systems, Wiring, Security system, Lawn sprinkler system
- Exterior work such as Storm windows/doors, New roof, New siding, Satellite dish
- Insulation in the Attic, Walls, Floors, Pipes and duct work
- Plumbing such as Septic system, Water heater, Soft water system and Filtration system
- Interior work such as Built-in appliances, Kitchen modernization, Flooring, Wall-to-wall carpeting and Fireplace
New paint may not qualify, but some “repairs” may qualify if done as part of a larger project to improve the home. Refer to IRS Publication 523 for a complete list of improvements that may qualify, citations below.
Expenses such as Fees and Closing Costs are deductible.
Here are some specific examples from the IRS of what DOES count as fees and costs you can include to reduce your basis on the sale of the home:
- Any sales commissions (for example, a real estate agent’s sales commission),
- Any advertising fees,
- Any legal fees,
- Any mortgage points or other loan charges you paid that would normally have been the buyer’s responsibility,
- Any other fees or costs to sell your home
Here are some specific examples from the IRS of what DOES count as fees and costs you can include to reduce your basis on the initial purchase of the home:
- Abstract fees (abstract of title fees),
- Charges for installing utility services,
- Legal fees (including fees for the title search and preparing the sales contract and deed),
- Recording fees,
- Survey fees,
- Transfer or stamp taxes,
- Owner’s title insurance, and
- Certain Costs owed by the seller that you paid. You can include in your basis any amounts the seller owes that you agree to pay (as long as the seller doesn’t reimburse you), such as: Any real estate taxes owed up through the day before the sale date, Back interest owed by the seller, The seller’s title recording or mortgage fees, Charges for improvements or repairs that are the seller’s responsibility (for example, lead paint removal), and Sales commissions (for example, payment to the seller’s real estate agent).
Therefore most sellers will have some additional deductions to calculate and may need to dig through old receipts to add up their improvements to the property over the years.
How Do I Avoid Capital Gains Taxes?
There’s no magical solution here, but some tax strategies such as installment sales can reduce or defer the tax obligations. A 1031 exchange is likely the best real estate tax incentive available, but that only applies to investment properties, not a primary residence. Though there are ways to utilize the 1031 exchange with long-term planning. See our 1031 article(s) for more information (link to 1031 article here). https://lucas-real-estate.com/1031-exchange-overview/
Beyond that, call your state and federal elected officials and let them know your thoughts on capital gains taxes. Pay attention to political candidates’ positions on tax policy when voting if these issues concern you.
Examples of IRS Section 121 Application
If you are married and purchased your home for $1,300,000 and sell it for $1,700,000, and you qualify for the 121 exclusion (since you both lived in and both owned the home for more than the past two years), you will owe zero capital gains taxes. (i.e. $400,000 gross profit [$1,700,000 – $1,300,000], less the $500,000 exemption is greater than the profit, so no capital gains taxes due).
If you are single and purchased your home for $300,000 and sell it for $700,000, and you qualify for the 121 exclusion (since you lived in and owned the home for more than the past two years), you will owe capital gains taxes on $150,000. (i.e. $400,000 gross profit [$700,000 – $300,000], less the $250,000 exemption, is $150,000).
If you are married and purchased your home for $300,000 and sell it for $700,000, and you qualify for the 121 exclusion (since you both lived in and both owned the home for more than the past two years), you will owe zero capital gains taxes. (i.e. $400,000 gross profit [$700,000 – $300,000], less the $500,000 exemption is greater than the profit, so no capital gains taxes due).
If you are single and purchased your home for $500,000 and sell it for $700,000, but you only purchased the home one year ago, and you are therefore not eligible for the 121 exclusion, you will owe taxes on the entire $200,000 profit. (i.e. $200,000 gross profit [$700,000 – $500,000], no exemption, thus the entire profit is subject to capital gains taxes).
Rolled Over Prior to 1997?
As noted, these rules have been in place since 1997. Prior to 1997, different rules applied that let homeowners avoid capital gains taxes by rolling their profits into another home, as long as the purchase price of the new house was equal to or greater than the home they sold. If you did sell a home and roll over prior to 1997, and now sell, you may essentially owe those deferred taxes back by a reduction in the tax basis of your current home by the amount of taxes rolled over. For example, if you rolled $200,000 of capital gains from previous home sales into your current home, $200,000 would be subtracted from your tax basis on this home (i.e. you are exposed to that additional $200,000 in “capital gains” on this sale).
Questions or Need Help?
Thinking of selling California real estate, we would love the opportunity to assist – we provide full service sales in Newport Beach, Costa Mesa and surrounding areas. If you are seeking to sell your home in Newport Beach, Costa Mesa or the surrounding areas, call or email anytime for a free brief consultation – email@example.com or 949-478-1623.
We provide advice and consultation for sales throughout the state of California. Call or write anytime or book a consultation. Paid one-hour confidential legal consultations are conducted daily via Zoom and address virtually all questions, options, tax implications and strategies. (Book a consultation here.)
– Devin Lucas
Author Devin R. Lucas is a Real Estate Attorney, Broker and REALTOR®, specializing in Newport Beach, Costa Mesa and Orange County coastal communities, serving individual and investors in residential real estate.
- IRS Topic No. 701, Sale of Your Home (https://www.irs.gov/taxtopics/tc701).
- IRS Publication 523, Selling Your Home (https://www.irs.gov/publications/p523)
- LA Times article: https://www.latimes.com/business/story/2022-06-26/how-previous-home-sales-might-hurt-you-when-figuring-capital-gains-tax
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