Will you have to pay capital gains tax on a home sale?

Selling a property can be a bittersweet experience. You'll be leaving the place you've called home, perhaps for decades. But you may also be pleased to find that you'll be making a nice profit on the sale.

Neighborhood changes, improvements to the home, and overall appreciation in home prices can all elevate your property's value above what you initially paid for it. If you're getting a particularly nice windfall, however, you might have to pay capital gains tax on the sale.

Most sellers will not have to worry about this tax, since it will not apply to the majority of residential sales. But there are also certain exceptions that will allow you to avoid capital gains tax.

To qualify for the capital gains tax, your home's value must be much higher than the initial purchase price. Cathie Ericson, writing for the National Association of Realtors, says individuals selling a home won't qualify for capital gains tax unless they make more than $250,000 on a sale; for married couples, the threshold is $500,000.

Kay Bell, writing for the financial site Bankrate, says homeowners once had to roll the profits from a home sale into the purchase of a more expensive home if they wanted to avoid taxes. Sellers above the age of 55 were allowed to exempt up to $125,000 in profits, but could only do so once in their lifetime.

The rules were modified in 1997, and they apply to current sales even if you purchased your home prior to that year. In addition to changing how capital gains taxes apply, the legislation provided that homeowners no longer need to buy a new home to avoid the taxes on any profits.

The change aimed to relieve the tax burden on people selling their primary residence, but it does not apply to second homes or investment properties. In addition to staying within the profit limits, you can only avoid capital gains taxes if the property was your primary residence for at least two of the past five years. This means you can effectively claim the capital gains tax exclusion every two years if you are changing residences that often.

Even if the value of your home has skyrocketed during your time there, you might still be able to fall within the acceptable profit limit. This is where it is useful to have records of your home improvements on file. Michele Lerner, also writing for the National Association of Realtors, says the total amount that you have spent on improvements during your time in the residence can be subtracted from the total profit you reap on the sale.

Other costs can also be deducted from the sale's profit. Stephen Fishman, writing for the legal site Nolo, says these expenses can include points or prepaid interest on the mortgage, real estate commissions, title insurance, and administrative costs.

In addition, Lerner says the amount of money you owe will depend on your tax bracket. If you made a nice profit on the home sale but your income puts you into a lower tax bracket, your capital gains tax rate might be zero.

Some relief is available for sellers who do not meet the two-year residency requirement due to special circumstances. Fishman says sellers who have entered a nursing home only need to have lived in their previous residence for one of the past five years to qualify for the capital gains tax exclusion. Partial exclusions are available for sellers who have to move due to unforeseen circumstances, such as a change in employment.

Marital situations can also have a significant effect on your taxes. A seller can qualify for the higher profit limit if he or she gets married before the end of the year, as long as their partner also meets the residency requirement. Divorced and widowed partners can also use their former partner's time in the property to meet the residency requirement.

Since military personnel change residences more frequently, legislation was passed in 2003 to make an exception on the residency requirement. Bell says this military personnel are now exempted from this requirement for up to 10 years, allowing them to qualify for capital gains tax exclusions whenever they need to move and sell their home.

Homeowners were once able to move to a second home, make it their primary residence for two years, and again qualify for the full capital gains tax exclusion upon sale. However, new rules now only allow a partial exclusion based on how long the property served as a secondary rather than primary residence.

One way to avoid capital gains tax on a vacation or investment property is a 1031 exchange. Ericson says this involves using the profits of the sale to purchase another investment property, thus putting the proceeds back into real estate instead of your bank account.

Steven Merkel, writing for the financial site Investopedia, says not all exchanges will qualify for a capital gains tax exclusion. If you receive any additional property or cash to make the exchange more balanced, this value is subject to taxation. You also won't qualify if the trade involves a personal residence or a property purchased outside the United States.

Most home sales will fall well within the profit limit, so sellers typically don't have to worry about the capital gains tax. A tax adviser, accountant, or attorney can help you find exceptions if you think you will make a substantial profit on your property.

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