How capital gains taxes affect home sales and how to avoid them

Real Estate | 17 Aug |

Homeowners in Greater Phoenix have seen their property values rapidly rise over the last two years. Data from the S&P CoreLogic Case-Shiller Indices show that, in May 2021, Phoenix experienced a 25.9% one-year increase in house prices, leading the nation for the 24th consecutive month. The impressive growth has led some to sell and capture the earnings while the market is still hot. Those expecting an exceptional profit, however, should be aware of potential capital gains tax liabilities stemming from home sales.

“Taxes are something that people are really afraid of. And, frankly, most people should be because they don’t understand them,” says Tom Wheelwright, CPA, CEO of WealthAbility and author of “Tax Free Wealth.” “Capital gains are not separate from income taxes, they’re just a different rate on a different type of income. We normally think of income tax on money we earn or collect from rent. Anything that is an income based on time, like appreciation on a house or stock, is subject to capital gains tax rates, which are historically lower than ordinary income rates.”


READ ALSO: Phoenix leads nation with 25.9% home price increase


When a home is sold, the profit is considered a capital gain and thus exposed to taxes. There is, however, an exemption for the first $250,000 in profit for a single person or $500,000 for married couples, so long as the owner has lived at the property for two of the last seven years.

Tom Wheelwright is a CPA and CEO of WealthAbility.

“For example, let’s say you paid $300,000 for your house. You’ve lived in it for five years, and you sell it for $500,000. That’s $200,000 in profit and you get a $250,000 exclusion, so you’re not going to pay any capital gains tax,” Wheelwright notes. “But if you are single and sold it for $700,000, now you have $400,000 of capital gains so you’re going to pay capital gains tax on $150,000 — the difference between that $400,000 gain and $250,000 exemption.”

If the proceeds from a transaction require capital gains taxes to be paid, that liability can be settled after closing or during tax season. The period of time between the sale and filing taxes — potentially months depending on when the house was sold — can leave unaware sellers unprepared for a surprise bill from the IRS. While this is an issue typically faced by luxury homeowners, Wheelwright says that’s no longer the only case. “There are lots of people who’ve owned their homes for a long time. With the increase in housing prices, they’re going to owe some capital gains tax if they sell.”

This issue is especially salient for people wanting to take advantage of their home’s high valuation to upgrade their living conditions. “Imagine selling your house for $800,000 and buying a new one for $2 million because interest rates are so low,” Wheelhouse says. “Now you’ve got all this extra debt, and you already put your profit into the new house. How are you going to pay your taxes if you already spent those gains? You’re not going to be able to get a home equity loan.”

There are ways to reduce capital gains liability from home sales. Improvements made to the property, such as putting in new flooring, adding a pool or remodeling the kitchen, reduces the seller’s gain. The government also has incentives which provide tax deductions if capital gains are spent in certain ways. For example, investments in real estate, oil wells and start-up costs for a business all qualify as tax deductions.

“There’s a dollar-for-dollar tax credit for putting solar panels on your roof. Credits are better than deductions because they’re not based on your tax rate, they’re 100% of whatever the allotted credit amount is,” Wheelhouse maintains. “If you put $100,000 of solar panels on your house, you get a $26,000 offset to your income tax. Remember, anything that you can do to reduce your income taxes equally reduces your capital gains taxes.”

Wheelhouse says that tax incentives are the government’s way of encouraging spending towards its goals. “You’re taking a risk with your money the way the government wants you to, and doing so provides you with a tax benefit as compensation. The government is your partner — you either are a silent partner or you’re an active partner investing the way it wants you to.”

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