How to avoid capital gains tax on real estate

They say the only certainties in life are death and taxes — but it actually is possible to avoid the capital gains tax on real estate.

Lindsay Frankel

July 21, 2023

It’s important to understand what your tax burden may be before selling your home, especially if you’re taking on a new mortgage at today’s sky-high rates. 

Real estate tends to appreciate, and if you stay in your house for long enough, you can make a pretty steep profit when it comes time to sell. But the IRS may be entitled to a share of your earnings, depending on the amount of your capital gains and your personal situation. It’s important to understand what your tax burden may be before selling your home, especially if you’re taking on a new mortgage at today’s sky-high rates. 

We’ll cover everything you need to know about capital gains tax on real estate. With the right information, you may be able to avoid paying capital gains tax altogether.

How does capital gains tax on real estate work?

Let’s say you and your spouse paid $400,000 for your house many years ago, and you accept a $1,000,000 offer from a buyer. When the sale is complete, you’ll have $600,000 in profit. In some situations, you may be required to pay capital gains tax on that $600,000. But if you’re selling your primary residence, you can take advantage of the capital gains exclusion, assuming you meet the requirements. This would allow you to exclude some of the profits from your taxable income. 

If you qualify, you can exclude:

• $250,000 in capital gains for single filers
• $500,000 in capital gains for married couples filing jointly

In this example, you’d be able to avoid paying taxes on $500,000 of your earnings if you and your spouse file jointly. That means you’d only have to worry about paying capital gains tax on the remaining $100,000. For most people, the capital gains tax rate is 15%. 

However, keep in mind that your cost basis includes not only the price you paid for the home, but also any money you put into capital improvements. So if you spent at least $100,000 updating your home — whether that was new flooring, new siding, a new roof, or a new addition — you’d be off the hook. (Tip: A home equity line of credit can help you cover the costs of those renovations.)

When do you pay capital gains tax on real estate?

You may pay capital gains tax the year you sell your property if any of the following are true:

• You earned more than the allowable exclusion: If you sell your house and earn more than $250,000 as a single filer or $500,000 as a joint filer, you’ll be required to pay capital gains tax on any profits above that amount. 
• You’re selling a second home or investment property: The IRS states that you can only have one main home, or principal residence, at a time. If you only own and live in one home, that’s your primary home. If you own more than one home, your principal residence is likely the place where you spend the most time. Other factors are important as well. For example, the address you use on your tax returns, driver’s license, voter registration, and vehicle registration is likely your principal residence in the eyes of the IRS. If you’re selling a rental property or a second home that isn’t your principal residence, you won’t qualify for the capital gains exclusion. 
• You didn’t own the property for long enough: You can generally only take the capital gains exclusion if you or your spouse owned the property for at least two years out of the five years prior to the sale. However, you may qualify for a partial exclusion of gain if you sold your home due to a work-related move, health issue, or unforeseeable event. 
• You didn’t live in the property for long enough: If you didn’t live in the home for at least two out of the five years prior to the sale, you won’t qualify for the exclusion. However, those 24 months don’t need to be consecutive, and a vacation won’t count against you. If you were in the military or needed outpatient care, you may also qualify for an exception. 
• You recently claimed the exclusion on another home: You can only claim the exclusion once in a two-year period. 
• You acquired your home through a like-kind exchange: If you originally bought your home as an investment property through a like-kind exchange, which allows you to defer capital gains by reinvesting in a similar property, you won’t be eligible for the capital gains exclusion when you sell your home. 
• You pay expatriate tax: If you live abroad and are no longer a U.S. resident for tax purposes or have renounced your citizenship, you may be required to pay an expatriate fee based on the value of your U.S. property in certain circumstances. If you pay expatriate tax, you’re automatically disqualified from taking the capital gains exclusion. 

How is capital gains tax on real estate calculated?

To calculate your capital gains, first calculate your cost basis. Add the price you paid for your home, plus any money you spent on capital improvements, and subtract any casualty loss amounts (like insurance payouts) or depreciation amounts. Then, subtract your cost basis from the sale price for your home, along with your selling expenses. The resulting amount is subject to capital gains tax — unless the home is your principal residence and you qualify for the capital gains exclusion. 

Capital gains = sale price - selling expenses - (purchase price + capital improvements - losses or decreases)

Note that if you inherited your home, your cost basis starts with the home’s value when the previous owner passed away, not the price your predecessor paid for the home. 

If you owned your home for more than a year, you’ll be taxed at the long-term capital gains rate. For most people, that rate is 15%, but if you’re a high-earner, you may pay 20%. Some low-income homeowners pay 0%. The rate you pay will depend on your income for the year. 

However, if you own your home for one year or less before selling it, your gains will be taxed as ordinary income. That means you’ll pay between 10% and 37% of the profits to the IRS, depending on your tax bracket. 

Who pays capital gains tax on real estate?

The homeowner who is selling the property pays the capital gains tax, rather than the new homeowner who buys the property. Homeowners who don’t qualify for the capital gains exclusion will be liable for capital gains tax, as well as those who earn profits above and beyond the allowable exclusion. 

How to avoid capital gains tax on real estate

• Own and live in your house for at least two years before you sell: If you previously rented out your home, you may opt to make it your principal residence for two years before you sell, which may qualify you for the capital gains exclusion. 
• Sell before your profits exceed the allowable exclusion: If your home has already appreciated up to the allowable exclusion, you may opt to sell now to avoid paying capital gains tax. You can put the money into a new home and qualify for the exclusion again in a few years. 
• Sell before you file for divorce: If you’re planning to get divorced, you may want to sell your home first. You’ll qualify to exclude twice as much in capital gains. 
• Sell when you’re earning less: You can time the sale of your home to be in a year when your income is low enough to qualify for the 0% capital gains tax rate. If you have the flexibility, reducing your income for a year may be worth the tax benefits. But this is typically not possible for most people. 
• Keep track of home improvements: Hold onto your receipts for renovation projects, since any money you spend will increase your cost basis. A higher cost basis means lower profits to pay capital gains tax on. 
• See if you qualify for a partial exclusion: If you were forced to move due to a job, health issue, or other circumstance, you may be eligible for a partial exclusion of gain. 

Bottom line

Whenever you earn money from the sale of an asset, the IRS will likely want a piece of the pie. And if you’re liable for paying a hefty capital gains tax, it may impact how much mortgage you can afford on a new home.

Fortunately, homeownership provides many tax benefits, including the capital gains exclusion for principal residences. If you’re careful about meeting the requirements and timing the sale of your home, you can avoid giving even a cent to the IRS. That’ll give you more cash for a down payment on your next home.

Editorial Disclosure: All articles are prepared by editorial staff and contributors. Opinions expressed therein are solely those of the editorial team and have not been reviewed or approved by any advertiser. The information, including rates and fees, presented in this article is accurate as of the date of the publish. Check the lender’s website for the most current information.

This article was originally published on SFGate.com and reviewed by Lauren Williamson, who serves as the Home and Financial Services Editor for the Hearst E-Commerce team. Email her at lauren.williamson@hearst.com.

Written By

Lindsay Frankel

Lindsay Frankel is a freelance financial writer who gets jazzed about empowering people to make smart financial decisions so they can keep more of what they earn. Whether she's evaluating insurance companies or comparing personal loan rates, she treasures the opportunity to demystify financial products so people can find the right option for their needs. She’s had more than 600 personal finance and financial services articles published during her 8-plus year writing career. Her interest in finance extends to her personal life, too — she saves money like it’s going out of style. Lindsay began her career at an affiliate marketing company, writing about both shopping and personal finance topics. Since launching her freelance business in 2018, Lindsay has written for over a dozen publications, including LendingTree, NextAdvisor, BiggerPockets, Investopedia, The Balance, FinanceBuzz, Bankrate, FinImpact, and Insurify. Lindsay graduated magna cum laude with a bachelor's degree in education from Elmhurst College.

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