Any potential homebuyer who is struggling to find an affordable home might never imagine that some lucky folks actually could be thinking twice about selling their house because they’d make too much money.
Seriously?
Buzz has been building in the real estate world about an out-of-date tax threshold relating to potentially taxable profits some people face when selling a home that they’ve lived in for years. Some call it a “hidden home equity tax.”
It wasn’t supposed to be this way.
When Did We See the First Capital Gains Break on Home Sales?
Some 30 years ago, then-President Bill Clinton called for allowing married couples to keep up to a $500,000 profit — tax-free — from the sale of their principal residence. Both Democrats and Republicans liked the idea and it was included in sweeping changes when Congress passed the Taxpayer Relief Act of 1997.
The initial limit seemed so high at the time that it was viewed as essentially eliminating the capital gains tax on the sale of your primary home.
Except, the limit for that threshold was never indexed to climb higher based on inflation or rising home values. As a result, more people than some might imagine do not qualify for the home sales exemption, depending where you live. And the number is expected to continue to grow if home values keep climbing.
Currently, an individual who sells a home is permitted to keep up to $250,000 in capital gains on the sales of a house they’ve owned and used as a principal residence for at least two years of the prior five years leading up to the date of the sale.
Married couples who file jointly don’t face taxes on up to $500,000 in capital gains on a similar home sale.
“That number really hasn’t kept up with the times,” said Joel Berner, senior economist for Realtor.com.
Berner said the risk of paying any capital gains tax on the sale of a home isn’t well known by many people because the 1997 exclusion had for decades been big enough so that the tax wasn’t triggered for many sales of a primary home. No one even talked about this issue for years.
Your odds of getting caught by the capital gains tax will vary significantly depending the price appreciation for homes in your community, how long you lived in that home, the state where you live and whether you’re married or single.
Hot Spots for Capital Gains Could Grow
New research by the National Association of Realtors estimates that nationwide about 13.1 million homeowners — 15% of all owner-occupied households — already have unrealized capital gains in their homes that exceed the limits allowed for the capital gains tax break.
In Michigan, it’s estimated that 5.5% of homes exceed the limit currently. In Minnesota, it’s 7.7%. In New Jersey, it’s currently 22.6%. In California, it’s 43.6%, according to this study.
Many more homeowners could face this tax burden if home values grow as expected, and the study has some pretty lofty forecasts for how many people ultimately could be at risk should we see some robust home appreciation in future years.
A 30% increase in home prices nationwide would effectively double the exposed homeowners to over 27 million households — or 31.3% of households nationwide in upcoming years, according to the study.
The study notes that since 1997, U.S. home prices have risen about three and a half times at the national level, and even faster in many metropolitan areas. Many communities saw some serious price growth in 2021 and 2022 after a huge surge in demand following the start of the COVID-19 pandemic.
In a lot of Midwestern markets, the risk continues to remain fairly low.
What Kind of Tax Change Do Some Want?
Even so, many real estate professionals would like to see big changes in the limit, perhaps doubling the thresholds to $500,000 for singles and $1 million for married couples or eliminating the capital gains tax on primary home sales entirely. They say this is a way to free up some housing supply, fuel home sales in some markets, and possibly prevent more issues down the road.
“It just unlocks the housing market,” Berner said. “It allows for more transactions and more flexibility for people to move up.”
The theory is that housing supply also is influenced by the willingness of existing homeowners to sell their homes and move.
Berner said raising the limit would give more people, including older adults, more flexibility when it comes to selling their homes without worrying about a bigger income tax bill.
“The people who are most penalized are people who have been in homes for a long time,” Berner said.
Maybe they bought during a major dip, such in early 2011 after the financial crisis hit. Maybe they are older adults who have been living in the house for 30 years or more.
Some Argue Only a ‘Small Group of High Income’ Taxpayers Would Benefit
Make no mistake, most people do not face paying any capital gains taxes on the sale of their home, especially if they are married, living in an area with modest home values and they’re not looking at a gain of more than $500,000 on the sale of their home.
And raising the tax-exempt level of capital gains on a primary residence would do little to meaningfully increase housing supply, according to Elena Patel, co-director of the Urban-Brookings Tax Policy Center and senior fellow.
Such a tax change, as being proposed by some in Congress now, “would provide large benefits to a small group of high-income, high-wealth households,” according to research by the Urban-Brookings Tax Policy Center.
Most households, Patel said, already owe no capital gains tax when selling a primary residence under current law.
Under current law, the report noted, 95% of all households — and 90% of households age 65 and older — would owe no federal capital gains tax on a home sale because their accrued capital gains fall below existing exclusion thresholds.
“Expanding the exclusion would therefore mainly provide additional tax benefits to a relatively small group of higher-income, higher-wealth households, while having limited effects on overall housing availability,” Patel said.
“It would also further increase tax preferences for households that already receive substantial housing-related tax benefits, including through the mortgage interest deduction.”
Who Might Be Vulnerable?
The study noted that many older homeowners who have aged in place following widowhood or divorce could be hit by unexpected capital gains taxes on the sale of a home owned for many years.
“Single filers account for roughly 58% of exposed homeowners,” the report states.
Others who might be vulnerable include homeowners who bought their house before the major price increases of the early 2000s and post-2012 period.
California stands out, driven by both a large homeowner base and decades of strong price appreciation, the report said. But other large states, such Texas, Florida and New York, also show sizable numbers of homeowners with gains above $250,000 simply due to the scale of their housing markets, the report stated.
It’s hard to judge what might stop an older homeowner from selling and just paying the taxes to unlock their own wealth. But some could be wary of paying more in taxes.
Longtime homeowners are having to “deal with maintenance costs, rising insurance and all these things that make it difficult for them to afford the big home. But if they sell the big home, they get hit with this capital gains tax. So, they’re deciding to stay in place,” Berner said.
How the Capital Gains Tax on Home Sales Works
How much you’d actually pay in taxes could vary significantly.
Say you’re single and bought that house in 1996 for $120,000 and now can sell it for $420,000. In that example, a single person might be looking at some level of taxable gains. But how much you pay in taxes could be smaller than you’d think.
“One of the biggest misunderstandings is that homeowners think the entire gain becomes taxable once they exceed the exclusion amount. That is not true,” said Tom O’Saben, director of tax content and government relations at the National Association of Tax Professionals.
A single filer can generally exclude up to $250,000 of gain, and married couples filing jointly can exclude up to $500,000 if other rules are met.
“Only the gain above those thresholds is potentially taxable, assuming they meet the other rules,” he said.
Maybe you’re looking at a $50,000 taxable gain in this example, maybe you’re not.
To be sure, you want to do your homework to reduce your tax bill. “Expenditures for home improvements can increase your basis in the home and, therefore, reduce your gain,” said Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting in Riverwoods, Illinois.
We’re talking about reducing your taxable gain by taking into account big expenses that you faced to improve the home, maybe a kitchen remodel, new additions or adding a new HVAC system. Not costs for regular upkeep, such as painting your bedroom.
“Closing costs on the sale allocated to the seller can also reduce gain,” Luscombe said. “However, any depreciation claimed over the years from business or rental use of the property may reduce basis and increase gain.”
Taxpayers should take the time to make sure they calculate their cost basis correctly.
Long-term capital gains for property held longer than one year are generally taxed at preferential federal rates of 0%, 15% or 20%, depending on income, O’Saben said.
For many middle-income taxpayers, an extra $50,000 of taxable long-term gain could create roughly about $7,500 in federal tax at a 15% capital gains rate.
State tax rates vary. Some states have no income tax, while others tax capital gains as ordinary income. In a state with a 5% income tax, O’Saben said, $50,000 of gain could add roughly another $2,500 in state tax.
And you want to make sure you’re eligible for the exclusion.
“Generally, you’re not eligible for the exclusion if you excluded the gain from the sale of another home during the two-year period prior to the sale of your home,” according to the Internal Revenue Service.
Luscombe said some unique situations can crop up that can disqualify you from the exclusion, too.
“Some people forget that you need to wait two years before claiming the exclusion again,” Luscombe said.
“It can come up, for example, when a couple gets married and one spouse sells their home and moves in with the other, and then they quickly start looking for a larger home and sell the other spouse’s home within the two-year period.”
Or in some cases, he said, people may forget that any gain associated with depreciation claimed on the home after May 6, 1997, from business or rental activity is not eligible for capital gains exclusion and may be taxed at a 25% capital gain rate.
We’re talking about some fairly complicated rules. And yes, there are some exceptions — a partial exclusion might be available if the full two-out-of-five-year rule is not met in some circumstances, Luscombe said. Consider changes in employment, health reasons, or other unforeseen circumstances, such as divorce, legal separation, multiple births from the same pregnancy, or natural destruction or condemnation of residence.
Obviously, even advocates acknowledge that raising the limit for the capital gains exclusion will not fix all the problems associated with a limited supply of homes. Much more needs to be done.
“The biggest piece is building more homes. Anything that encourages builders to deliver inventory is really the ultimate solution,” Berner said.
In general, he said, there should be about 4 million more homes in the United States — or an increase of about 5% — to match the number of households.
