Selling your house comes with expenses, such as commissions, listing fees, costing costs, and capital gains taxes. Some of these costs, including capital gains taxes, may be exempt if you meet certain circumstances.
A capital gains exemption allows homeowners who have owned the property for at least two years to avoid paying capital gains. Learn everything you need to know about the two-year ownership rule and how to calculate capital gains taxes.
We’ll also review a few alternatives to minimize tax penalties. Use this guide to avoid paying short-term capital gains.
2-Year Ownership Rule
A home is considered an asset, making it tax-liable following a sale.
A key tax exemption applies to sellers who have owned and lived in their home as a primary residence for at least two years within the five-year period before selling. This two-year requirement doesn’t need to be consecutive to qualify for the exclusion.
Capital Gains Tax
Capital gains taxes are taxes owed on the profits earned from selling a house. They are designed to collect a percentage of the profits from an investment property, which means property owners can often avoid paying capital gains taxes on a primary residence. Capital gains are taxed at between 0% and 37% based on household income.
Primary Residence Exclusion
Primary residences are exempt from capital gains taxes since they are designed to profit from real estate investors. Section 121 from the Internal Revenue Service (IRS) lists that gross income earned from the sale of a primary residence is not subject to capital gains taxes as long as the owner has lived on the property for at least two years. [1]
A primary residence means that the owner lived in and used the property as their main home for the required period. Selling a house before two years usually requires you to pay capital gains tax on a cost basis.
Real estate taxes are calculated based on the profits earned after you sell your home. This arrangement means sellers can deduct ongoing expenses, fees, and commissions paid to real estate agents.
Penalties for Selling Before 2 Years
Selling a property before two years of ownership may result in financial penalties, including capital gains taxes owed. Selling before two years triggers short-term capital gains, which are taxed at a higher rate than long-term capital gains.
The two-year rule allows property owners to prorate the tax penalty. For example, if the owner lived in the property for one of the last five years, they may benefit from the exemption for that single year. However, they would still owe some long-term capital gains.
It’s also important to note that some sellers may pay taxes on recaptured depreciation deductions, depending on how long they owned the property before the home sale.
Calculating the Penalty
How much a seller owes in penalty depends on their profit earned, income level, and filing status. Additionally, the length of time the property owner owned the home is also a factor in the taxes owed.
Capital gains tax is calculated as a percentage of the profits earned, so higher-profiting assets are subject to higher taxes. The seller’s income level also affects the capital gains tax rate. Thus, higher-earning taxpayers will pay a higher tax rate than those with lower income levels.
Filing status also affects capital gains. Sellers who are single or married filing single are exempt up to $250,000, and sellers who are married couples filing jointly are exempt up to $500,000.
The capital gains tax rate is usually between 0% and 37%, depending on these factors.
Exceptions to the 2-Year Rule
There are exceptions to the two-year rule, such as those who must move for work or health reasons. Selling for unforeseen circumstances can also prevent some sellers from paying capital gains taxes. However, sufficient documentation is needed to meet these exceptions.
Qualifying for the capital gains tax exclusion requires proof that the property was a primary residence for at least two years. This evidence may include utility bills, voter registration cards, driver’s licenses, or tax returns.
If you have to sell your house before two years, it may be worth consulting a financial advisor to understand the associated financial costs better. A tax penalty for selling too soon can significantly reduce your profit.
Calculating How Much to Pay Capital Gains Taxes
Learning how to calculate capital gains taxes can help sellers prepare for the cost. Here are a few methods of calculating capital gains tax payments.
Cost Basis
Cost basis refers to the purchase price of a property plus its costs or the difference between the price you paid and its selling price. This difference could be any significant improvements that added value to the home.
Capital Gain
To determine the capital gain of your property, add up the costs, including the purchase price, real estate professional commissions, repairs, or renovations. Subtract this cost basis from the property’s sale price. If the value is positive, you have a capital gain. If it is negative, you have a capital loss.
Tax Rates
Capital gains tax rates are dependent on income level and filing status. Additionally, how long you owned the property further impacts the tax consequences.
Capital gains are taxed based on income level, tax bracket, and filing status.
For example, in 2024, single filers who earn less than $44,625 or married couples filing jointly and earning less than $59,750 fall into a 0% tax rate, whereas those with earnings between $44,626 and $492,300 are subject to a 15% tax rate. High-earners pay a capital gains tax rate of 20%. Keep in mind that these tax brackets change annually. [2]
The length of ownership also impacts capital gains taxes. Property ownership for less than a year is subject to short-term capital gains, which are taxed between 10% and 37% at ordinary income tax rates [3]. Property held for more than a year is taxed as long-term capital gains based on taxable income and federal tax rates.
If you sell your home after one year, you will owe taxes on 50% of the sale profits.
Strategies to Minimize or Avoid Penalties
The best way to avoid paying capital gains taxes on a primary residence is to take advantage of the exemption. Selling a house can be expensive, with real estate agent fees, closing costs, and repairs. However, if you can avoid capital gains taxes, you can keep more of your profit.
Documenting Exceptions
Some exceptions may be available to those who owned a property for less than two years to avoid paying capital gains. For example, if you were required to sell your house due to a change in employment, you may submit documentation and avoid the tax penalty. However, the new job must be at least 50 miles from your home.
Sellers with a capital loss can also avoid capital gains taxes. There are limitations to how much capital losses can be offset against ordinary income, so always consult a tax professional. It’s also possible to offset the losses of one investment property with the capital gains of another, depending on the tax bracket.
Consulting a Tax Advisor
Always consult a tax advisor before selling a house to understand your tax burden better. The tax implications of selling aren’t always clear, and a professional is the best way to prepare for these costs.
Working with a professional can help you decide whether to sell your house before two years or wait to offset the costs. Sometimes, waiting to sell even an investment property may be a better financial decision than the incurred tax penalties of short-term capital gains.
Considering Alternatives
The best strategy to avoid capital gains tax is to hold the asset. By exploring other alternatives, you can avoid a tax penalty for selling your house before two years.
For example, turning your home into a rental property allows you to generate income while avoiding taxable capital gains. Renting versus selling can be a great strategy for those subject to long-term capital gains and who have a higher income tax rate.
Real estate investors with investment properties can also reside in each property for two years to meet the required capital gains exclusion. After two years, you can sell your home and avoid paying capital gains tax.
Property owners who prefer to sell their house before two years might also benefit more from a cash sale. While you still have to pay a capital gains tax, you could avoid the other costs of selling a house, such as repairs, renovations, inspections, or real estate agent fees. Selling your home faster can also help avoid ongoing property ownership expenses.
Explore Your Selling Options
Selling a house has tax implications. Property owners who sell a home before two years may be subject to a higher tax burden. Investors or property owners with high taxable income will pay an even higher rate.
Some sellers may avoid this tax penalty by living in the property for at least two years. Tax exclusions may also be available for those who want to sell without living on the property for the two-year mark.
A cash buyer may help sellers control selling costs and avoid paying the tax penalty for selling too early. A-List Properties buys houses in any condition, regardless of how long you have owned your home.
Contact us today at (972) 526-7042 for a free cash offer. You can also fill out our online form to start the fast and easy home sale process.
References: [1] IRS, [2] IRS, [3] Investopedia
Zach Shelley
Zach Shelley is a seasoned real estate investor with a diverse network spanning across the nation. As the founder of his own real estate venture, Zach is committed to offering innovative solutions to homeowners facing various real estate challenges.. Through his dedication and strategic approach, Zach continues to make a significant impact in the real estate industry, providing homeowners with alternative pathways to navigate their property transactions.
