7 Simple Ways To Sidestep Taxes After Selling A Home

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7 Simple Ways To Sidestep Taxes After Selling A Home

Selling a home can result in owing a giant capital gains tax bill to good ole’ Uncle Sam. If you follow this article’s proven advice, however, you can minimize or even sidestep home sales taxes all together. For most homeowners, 1 simple way to not pay taxes after selling a home is when selling a homesteaded residence (i.e., the primary home you’ve lived in for at least 2 of the past 5 years). However, if you’re selling an investment house or if your primary home’s value has increased significantly, you need to understand the rules for how to minimize your tax liability, legally. In this article we detail the legal, but simple steps that you can take to avoid paying taxes on the proceeds of your home sale so that you can keep more or even all your profits.

What’s in it for you

  1. How taxes work when you sell a home.
  2. Ways to avoid paying taxes after selling a house.

How Do taxes work when I sell a home?

Real estate is classified by the IRS as a capital asset, which is any type of tangible illiquid property like homes, cars, large equipment, and stocks and bonds. When selling a capital asset, like a house, any gains (i.e., profit) are generally taxable. How are gains determined for purposes of calculating taxes on a home sale? It’s simple, gains when selling a home equal the difference between the home’s sale price and the original purchase price minus expenses for things like closing costs, realtor commissions, and title fees. Additionally, if you made home improvements and have kept an accounting of those improvement costs, the IRS allows you to subtract those expenses from any gains. If you sell a home at a loss, there are no capital gains taxes owed and you instead can legally deduct that loss against other forms of taxable income.

Selling a principal home residence is exempt from having to pay taxes on gains up to $250,000 if single and $500,000 if married and filing jointly. Simply put, if you’re married and made less than $500,000 after selling a homesteaded residence, you and your spouse owe $0 in taxes and get to keep the entire profit from the sale.

Let’s “put pen to paper”. Say that you bought your home for $400,000 4 years ago and have lived in it since. Today, you sell it for $540,000 resulting in a $140,000 gross profit. After you subtract typical home sale expenses (commonly 10% of the sale price, so $54,000), your net profit equals $86,000. This gain is entirely exempt from all tax liability as it’s below the $250,000 threshold for singles and the $500,000 threshold for married and filing jointly couples.

Let’s now instead say that after 4 years you decide to rent out the home. How can you avoid paying capital gains tax on a rental property? The answer is: the same way. Homeowners turned landlords can sidestep all tax liability when selling a rent house if they sell it within 3 years of it having been turned into a rental (remember, the IRS exemption requires that you’ve lived within the home for only 2 of the previous 5 years).

What’s the difference between short-term & long-term capital gains?

When it comes to paying taxes after the sale of a home, there are 2 types of capital gains tax and unless you’re exempt or implement the advice here, you must pay short-term or long-term capital gains taxes. But not both. How can you figure out the difference between short-term & long-term capital gains and thus which tax applies to you? It’s no secret that IRS regulations are confusing, however, this is 1 rare exception. Short-term capital gains tax applies to assets that you’ve owned and sold in less than 1 year, and they are taxed at the same rate as your ordinary income. Long-term capital gains apply to assets that you’ve sold after 1 year of ownership, and they are taxed at the long-term capital gains tax rate.

2024 short-term vs. long-term capital gains tax rate thresholds

The difference between the tax rates of short-term and long-term capital gains is dramatic and it’s often in your best financial interest to hold capital assets for at least 12 months. The chart below compares the amount of taxes owed for short-term versus long-term capital gains:

Let’s revisit the example above and compare the amount of taxes owed on the $86,000 home sale profit. Instead of selling in year 4, you and your spouse sell in month 11 and are in the 24% tax bracket. The amount you’d owe in short term capital gains tax would equal $86,000 x 0.24 = $20,640 (instead of $0, ouch!).

7 Ways To Not Pay Taxes On A Home Sale

If a home has increased in value significantly, when you sell it, you may owe capital gains taxes. If you prepare your own taxes or even if you use a top-notch tax prep software, if you don’t understand home sale tax laws and loopholes, you could end up paying way more than you should.

Below are the 7 ways to legally avoid paying taxes when selling a home. These tax loopholes work no matter if the property you’ve sold is a homesteaded residence, rent house, or vacation property.

Own & live in a home for 2 years

We’ve already highlighted this way of avoiding home sale taxes but as the most used tax avoidance loophole, it demands to be expounded upon. Owning and living in a home as your main home for 2 out of the preceding 5 years makes that home a primary residence. You could even move out and convert it into a rental property for up to 3 years and this way of avoiding taxes on its sale would still apply. IRS section 121(a) allows eligible homeowners a tax exemption on home sale gains up to $250,000 if single and $500,000 if married and filing jointly.

Unforeseeable event exceptions

If you don’t meet the "2 out of 5" eligibility test, it’s still feasible to qualify for a home sold tax avoidance exemption via an exception. What does the IRS classify as an “exception”? Below are some scenarios that may meet the criteria of an exception to sidestep any tax liability on profits resulting from the sale of a home.

Move due to work

If you, your spouse, other owner with equity in the home, or roommate take a new job or are transferred to an existing job that is 50 miles or farther from your current home and from your prior job, you may meet the criteria to be eligible for a home sale tax exception.

Move due to health issues

If you or any member of your household needs to relocate to receive a diagnosis or to receive treatment, mitigate, or cure for a disease, illness, or injury, you may be eligible for a tax exception on profits derived from selling a home. Additionally, if you’re advised by a physician to move to aid with the medical or personal care of a family member, you may also qualify.

Unexpected events beyond your control

You could qualify for an exception to taxes on home sale profits when unforeseen events arise. Unexpected events that qualify for avoiding home sale taxes include condemnation or full destruction of a home resulting from events like tornadoes, hurricanes, and acts of terror.

Unforeseen personal circumstances

Unforeseen personal situations could qualify as another exception where a resident of your household passed away, underwent a divorce or legal separation, or twins or more are delivered during a single pregnancy.

Loss of job or income

Selling a home and being exempt from capital gains taxes can be justified in situations where individuals become unemployed or face a change in employment status that significantly hinders their ability to meet everyday living expenses.

Home improvement costs are tax deductible

After buying a house, homeowners often continue to invest in a home in the form of value-add improvements, which the IRS classifies as “capital improvements”. The cost of capital improvements helps a seller’s bottom line in 3 ways: (1) they are tax deductible, (2) they typically increase home value, and they ultimately (3) increase its selling price.

To realize home improvement tax benefits, it’s imperative that sellers keep detailed records and an accounting of each improvement. Provided you do, it will reduce the amount of taxes owed when selling because those expenditures increase a home’s cost basis. Said another way, home sale profits are reduced because you have incurred added costs. 

It is important to note that not all expenses for a residence can be considered a capital improvement. Repairs that are common and ordinary to maintaining a home, for instance, fixing a plumbing leak, painting walls, or having your HVAC serviced, are all examples of non-tax-deductible expenses.

You’re in the military & are relocated

U.S. military personnel may face the challenge of relocating, even if it is not their preference. When this happens, military homeowners often must move within a limited timeframe which can make it difficult for them to meet the "2 out of 5" exemption that is available to non-military homeowners.

The military relocation tax exemption enables eligible members of the military, foreign service, and intelligence community to extend the 5-year test period to a maximum of 10 years.

To be eligible, the location of the new duty station must be at least 50 miles from their current residence, or they must live in government housing under government orders for at least 90 days (or indefinitely). If they’ve lived in the home for at least 2 years, this regulation allows qualified military homeowners to delay a sale and still qualify for the home sale tax exemption. Said another way, they must have lived in the home for at least 2 out of the preceding 10 years.

Swap ‘till you drop with a 1031 exchange

When investors sell an investment property, the IRS encourages them to buy more real estate investments. Colloquially known as “swap ‘till you drop”, a 1031 exchange allows investors to use the gains from the sale of 1 property to buy 1 or more properties of equal or greater value. In so doing, they can defer paying capital gains taxes and when they pass away, their beneficiaries inherit the capital asset with their cost basis being reset to existing values (hence the colloquial term “swap till you drop”). However, using a 1031 exchange requires that very specific steps be adhered to and within a designated timeframe. If successfully executed though, substantial tax savings can be achieved when selling an investment home.

The below chart shows the power of the 1031 exchange real estate tax avoidance strategy. Within 20 years, investors can turn $100,000 into $4.626 million! Without it, they would owe taxes after each home sale, thereby limiting their purchasing power, and thus their portfolio’s value to just $1.756 million ($2.87 million less!).

Capital asset losses offset capital asset gains

If you find yourself in the position of having to pay capital gains taxes on a home you recently sold, you can minimize your tax liability by offsetting the sale’s profits with the losses of your other capital investments. For instance, depreciation on a rental home often results in positive cash flow, but for tax purposes, a paper loss. This is commonly referred to as tax-loss harvesting.

Receive sales gains over time

100% of sales proceeds in real estate closings are commonly received on the day a home is sold. Alternatively, some sellers may agree to, and may even be incentivized for tax purposes, to do what’s called an installment sale. Installment sales is a type of owner financing arrangement where an owner sells a property but does not collect full payment at closing. Instead, the seller receives one or more payments over time which allows sellers to spread out taxable gains over the term of the owner financed note. This can keep sellers within a desired tax bracket to further reduce their tax burden each year.

FAQs

  1. Is it possible to sell a house without paying taxes?
    Yes, it is possible to sell a house and not pay taxes. The most often used taxation loopholes include selling a primary residence or executing a 1031 exchange.
     
  2. How do I sell my house and avoid paying taxes on the profits?
    To be eligible for the homestead sale capital gains tax exemption, homeowners must have used the home as their primary residence for 2 out of the last 5 years (or 2 out of the last 10 years for military members).
     
  3. How does accumulated depreciation impact taxes owed on a rental home sale?
    Homes are depreciated over 27.5 years so, for example, if you bought a home 5 years ago for $100,000, you’ve likely depreciated (i.e., deducted) $3,636 each year ($18,182 over 5 years). When you sell, depreciation is recaptured which reduces your cost basis and increases your gains. In this example, your cost basis would not be $100,000, it would instead be $81,818. As such, accumulated depreciation recapture would increase the sold home’s taxes owed. 

Want To Sell Your Home & Not Pay Taxes?

Capital improvements and home price appreciation can result in massive sales profits, but the taxability of those profits is largely within your control. If you implement these strategies, you can limit or even pay $0 in taxes on home sale gains. Another real estate profit tax savings strategy is selling to investors like Good Vibes Homebuyers. Our team regularly implements tax savings strategies for its own portfolio, but more importantly, we regularly help home sellers execute tax avoidance strategies when they sell to us. Contact us right now to learn about how we can buy your home using strategies that result in you paying $0 in capital gains taxes.
 

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