More home sellers face capital gains tax bills: what you can do

The rise in property values has led to an increase in the number of homeowners who unexpectedly find themselves paying capital gains tax when selling their property. Despite the generous $500,000 capital gains tax exclusion for real estate, more and more homeowners are finding that the profits from selling their homes exceed the tax-free limit.

The data shows that about 8% of home sales last year had profits that exceeded the foreclosure threshold. That’s more than double the number from five years ago, according to a report by CoreLogic, a consumer information and analytics company.

While capital gains tax is affecting a growing number of homeowners across the United States, it is particularly noticeable in states with high property values. It also affects long-term homeowners who have seen significant increases in the value of their properties.

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So what can you do about capital gains taxes if your home has appreciated in value? Read on.

Capital gains tax affects more homeowners

The capital gains tax on home sales applies to profits from the sale of real estate. Homeowners can exclude up to $250,000 of net gains if they file as single and up to $500,000 if they file as married. Gains above those limits are subject to capital gains tax, at rates that can be as high as 20%, with an additional surtax for certain high-income earners.

To qualify for the capital gains tax exclusion for a home, the homeowner must live in the home as their primary residence for at least two of the five years preceding the sale. But remember: The IRS allows one primary residence at a time, and you can only claim this exclusion once every two years. For more on the rules for this tax break, check out Kiplinger’s report: The Capital Gains Tax Exclusion for Homeowners.

So what’s going on? One problem is that the exclusion limit is not adjusted for inflation. This means that the value of the tax break provided by excluding the sale of a home from capital gains tax has eroded over time.

As a result, states with high real estate values such as California, New York, New Jersey, Massachusetts, Florida and Colorado are significantly affected.
Homeowners in these areas generally have a better chance of making significant gains that exceed the exemption limit.

Avoiding Capital Gains Tax When Selling a Home: Documenting Your Expenses

visualization of a model house on stacks of currencies

(Photo source: Getty Images)

Several studies have shown that the prospect of a large tax bill can discourage homeowners from selling, even if they want to move to a smaller home or a more affordable neighborhood. But there are some strategies that can help mitigate the potential impact of the tax.

Documenting expenses for home improvements and renovations can reduce your taxable income. These costs can be added to the original purchase price of the home, thereby reducing your net taxable gain.

Consider a fictitious married couple who bought a home for $300,000 seven years ago and decide to sell it in 2024 for $850,000. Without any improvements, their capital gain would be $550,000, which exceeds the $500,000 exclusion for married couples filing jointly.

But imagine that over the years they made the following significant improvements, worth a total of $75,000:

Kitchen Renovation: $30,000
Bathroom Renovation: $20,000
New roof: $15,000
Adding a deck: $10,000

Their adjusted basis is now $375,000 ($300,000 purchase price + $75,000 improvements). The improvements reduce their capital gain to $475,000 ($850,000 sale price – $375,000 adjusted basis).

By documenting the home improvements (using this example), a couple filing a joint return can generally reduce their capital gain from $550,000 to $475,000, which would bring it below the $500,000 exclusion limit. As a result, they avoid paying capital gains tax on the sale of their home, potentially saving thousands of dollars.

Other moves to consider:

Tracking sales costs. (Real estate agent commissions, legal fees and other costs of selling your home can be deducted from your capital gains.)

Using exceptions. Partial exclusions may apply if the sale is due to a change of residence, health reasons, other unforeseen circumstances or other rules applicable to U.S. military service members, or if the sale of the home is due to separation, divorce or death of a spouse.

Capital Gains Tax on Home Sale: Summary

Despite the potential tax implications, some homeowners may need to sell their homes for a variety of reasons, such as high maintenance costs and rising property taxes. Others may decide that the benefits of liquidating high-value assets outweigh the potential financial drawbacks, such as capital gains taxes.

However, with careful financial planning and documentation, the impact of these taxes can be manageable. Consult a trusted and qualified advisor who can help.