The answer is typically yes, you can avoid paying capital gains tax when you sell your primary home, up to $250,000 for singles and $500,000 for married couples. In the Taxpayer Relief Act of 1997, Congress allowed those amounts to be exempt from taxation, but there are a couple of details to be aware of.
What is Capital Gains?
The government likes their cut of your income and the money that you make on money (interest, dividends or gains) is also taxed. Capital Gains is the increase in money that you make when you invest in something and then sell it later on. If you bought $100 of Tesla stock in 2019 and sell it for $2,000 in 2020 - then you made $1,900 of gain and that is taxable. The same is true of your house: you bought it in 2005 for $300,000 and now you sell if for $550,000, then you have a gain of $250,000 which is taxable.
How is your home exempt from capital gains tax?
The IRS has ruled that you can entirely avoid the capital gains tax on the first $250,000 (single) or $500,000 (married) of gains from the sale of your primary home. This is fantastic: avoiding taxes is one of the best ways to grow your wealth (it's not what you make, it's what you get to keep!). Keep in mind the following rules:
- You must have lived in this home as your primary residence for two of the past five years. So, you can't purchase a home and flip it a year later and avoid the tax. However, you can live in your home for 2 years, rent it out for the next 2 years and then sell it and still avoid taxes. Make sure that you have documentation that you actually lived there.
- You may only take advantage of this tax-free gain once every two years. So don't sell two different houses in the same 24-month period.
But I made Home Improvements!
Any home improvements get added to the amount that you paid for your home. This is known as basis. For instance if you purchased a fixer-upper for $200,000 and then completely renovated it for $150,000, you have put a total of $350,000 into your home, which is your basis. When you sell it 3 years later for $500,000 you have a gain of $150,000 ($500k - $350k). Make sure to save documentation on the costs of your improvements.
As with all things tax related, it's important that you meet the eligibility requirements of the IRS. Be sure to check the fine print on the official IRS website for more details.