If you’re planning to kick off the new decade in a new home, you’ve got your work cut out for you—and possibly capital gains tax.

A short list of the home buying process: Save up for a down payment, determine your budget, decide on your “must haves” and “nice-to-haves,” pick the neighborhood, get in touch with a real estate agent, tour perhaps dozens of homes, and apply for a loan. And everything becomes that much more challenging if you’re planning to move states, or even cities!

The home selling process isn’t that much simpler, but it carries one additional element to the whole process. You may get hit with a major tax bill when you finally close the sale. And when you don’t anticipate that tax bill, it often turns right into a tax debt that can haunt you for years to come.

We won’t bury the lede here: You probably won’t have to pay taxes on your current home when you sell it.

But, as all things involving IRS tax codes tend to be, it’s not quite as simple as that. There are plenty of circumstances that can factor in to whether or not some of your home’s sale value is taxed. Consider this your home selling guide to taxes.

Tax Basics of Home Selling

The principle guiding how you’re taxed on your home’s sale is the capital gains tax. Here’s a brief reminder of what that is:

Capital Gains Tax

A capital gains tax is levied on the difference between what you pay for an asset and what you sell it for. When you purchase an asset, the total you paid is called your basis. This can apply to financial assets—stocks and bonds—as well as tangible assets, like a car or real estate. If the value has increased when you sell that asset (as it often does in real estate), you’re taxed on the difference in value.

Capital Gains on Real Estate

The IRS has some fairly high thresholds before the capital gains tax kicks in. Generally, the IRS lets you exclude these totals from your capital gains:

• Up to $250,000 on real estate for taxpayers filing as ‘Single.’
• Up to $500,000 on real estate for taxpayers filing as ‘Married Filing Jointly.’

Not too shabby. In many markets, these thresholds means you likely won’t need to pay capital gains tax at all if your home’s value has gone up since you purchased it.

For example, if you are married and your home was purchased for $200,000, even if the value goes all the way up to $700,000, you won’t pay any capital gains tax on it. If you’re single and your home’s value has risen from $100,000 to $400,000, you’ll be expected to pay capital gains tax on only $50,000 of the total.

When will you have to pay capital gains tax?

As with just about any section of the tax code, exceptions to the rule abound. There are a number of factors that can end up disqualifying your sale from the capital gains tax exclusion:

• The real estate wasn’t your principal residence. If you own a vacation home and sell it at a profit, the capital gains tax will apply to the entirety of the change in value.
• You’ve claimed the exclusion within the past two years. If you recently sold a home and claimed your $250,000 or $500,000, the full capital gains tax will still apply.
• You didn’t meet one of these 2/5 rules. In the five-year period before you sell your property, you must both: 1. Owned the property for at least two years; and 2. Lived in the home for at least two years. If either of these boxes are not checked, you’ll pay tax on the whole gain. (There are exceptions for those with disabilities or who are in the military or certain other organizations.
• You’re an expatriate. If you’ve renounced your citizenship (typically for tax reasons), you won’t be able to access the exclusion.
• You used a 1031 exchange. 1031 exchanges are essentially a tool for deferring taxes on a property—usually an investment property—by swapping it for another property rather than selling it. If you acquired the house through a swap within the past five years, you can’t use the capital gains exclusion.

What is the capital gains rate?

Capital gains tax rates come in two different flavors: short-term and long-term.

• Short-term capital gains tax rate. This rate applies if you’ve owned the asset for less than one year. This rate will be equal to your ordinary income tax rate.
• Long-term capital gains tax rate. This rate applies if you own the asset for more than one year. This rate is typically more favorable; depending on your filing status and income, you’ll either pay 20%, 15%, or even 0%!

Keep Track of Your Home Improvements

While many homeowners won’t reach the totals needed for capital gains tax to kick in, others certainly will. It’s not hard to imagine a couple purchasing a home in L.A. for $2 million and selling it 10 years later for $3.5 million! But are they really on the hook for capital gains taxes on $1 million?

The short answer? Not necessarily.

The cost basis (Remember that?) isn’t simply determined by what you paid when purchasing the home. It also includes any improvements that you’ve made on the home over time. Most homeowners make some changes to their home over time, things like a kitchen remodel, an expansion, an ADU, a repaved driveway, HVAC replacement, or a complete landscaping redesign. These improvements can all be factored into the basis, adding to the total purchase price.

So keep those invoices and receipts! If that couple has put $100,000 into their $2 million home over the ten years they’ve lived there, when it sells for $3.5 million, they’ll only be exposed to capital gains taxes on $900,000.

Good Luck with Your Home Sale!

We may not be able to recommend neighborhoods, but can help you avoid a big tax bill while moving. Now that you have a good idea of how capital gains taxes work and how to avoid getting hit with a tax, you can move onto the important things: the paint color, the neighborhood, and everything in between.

If you’ve run into tax debt stemming from a capital gains tax on your home, talk to one of our expert tax professionals about getting IRS tax relief through our free live chat!