Despite the recent cooling of the housing market, many homeowners still made a substantial profit selling their homes in 2022. According to nationwide property database ATTOM, the average profit made on home sales in 2022 was $112,000, representing a 21% increase from 2021 and a 78% jump from two years ago. While most sellers are not subject to capital gains taxes, high-value sales or long-term ownership can trigger unexpected tax bills.
When a home is sold for a profit, the profits are considered capital gains and are subject to federal tax rates of 0%, 15%, or 20%, depending on the seller’s taxable income in 2022. To calculate taxable income, one must subtract the greater of either the standard or itemized deductions from adjusted gross income. As a single home seller, one can exclude up to $250,000 of the profit from capital gains taxes, while a married couple filing jointly can shield up to $500,000, provided they meet certain IRS rules. However, if the profit exceeds these thresholds, the seller may owe capital gains taxes, which can be a substantial tax burden for those who are unaware of it, especially if they have substantial appreciation and embedded gains, according to certified financial planner Anjali Jariwala, founder of FIT Advisors in Redondo Beach, California.
There are specific rules to qualify for the $250,000 or $500,000 capital gains exemptions. To meet the ownership test, the property must have been owned for at least two of the last five years before the sale. There is also a residence test that requires the home to have been the seller’s “primary principal residence” for at least two of the past five years, although it doesn’t have to be continuous. The IRS provides exceptions to the eligibility tests, including specific guidance for cases of separation or divorce, widowed taxpayers, service members, and others, which are outlined on their website.
There is potential to reduce profits, and possibly lower capital gains, by increasing a property’s purchase price, or “basis,” according to Jariwala. The purchase price of the home is the starting point for the basis, which can be increased by adding the cost of “capital improvements.” Examples of capital improvements include replacing the roof, putting in new floors, or adding a room. However, repairs and maintenance, such as painting or fixing leaks, cannot be included because they do not add value or prolong the home’s life.
When calculating home sales profit, expenses incurred to sell the home can be backed out, such as agent commissions or costs to fix up the property before selling. Jariwala recommends getting organized with receipts if planning to sell in the future to determine which expenses may reduce profits. Otherwise, one may be scrambling to figure out their basis before the tax deadline, potentially leaving money on the table.
If one expects a significant gain, it may be wise to consider the timing of the sale based on expected income for the year or leverage strategies to offset the tax liability. It’s essential to take a holistic approach to the tax return to maximize profits and reduce taxes owed.