How Taxes Can Affect Your Home Sale

You buy a home, the market booms and suddenly your property is worth a lot more than you paid for it. If you sell within a year, though, the IRS classifies those profits as short-term capital gains, which are taxed as ordinary income.

Depending on your tax bracket, that rate could be as high as 37%.

When capital gains become tax-free

If you’ve owned the home for at least two years and meet the IRS criteria for a principal residence, you may be eligible to exclude some of — or even all — those gains from taxation.

The exclusion limit is up to $250,000 for single filers and $500,000 for married couples filing jointly.

In the case of a spouse’s death, the $500,000 exclusion may still apply, even if you’re now filing as a single individual — as long as you meet all the following criteria:

• The sale happens within two years of your spouse’s passing.
• You haven’t remarried at the time of the sale.
• Neither you nor your late spouse used the exclusion on another home sold within the past two years.
• You meet both the two-year ownership and residency requirements.

How primary residence rules apply when you own multiple homes

Only one home can be treated as your principal residence — and this is the only property that qualifies for the capital gains exclusion. The key rule is the “two out of five years” test. If you lived in the home for a total of at least 730 days within the five years before the sale, it counts. Those 24 months don’t need to be consecutive.

For married couples claiming the full $500,000 exclusion, both spouses must meet the residency requirement, even if the property is owned by just one of them. You can also offset gains from your home’s sale with unrelated capital losses from the same tax year.

That said, this exclusion can only be used once every two years.

What about investment properties or second homes?

If the property you’re selling is a rental or an investment asset, the exclusion doesn’t apply — even if you used it for personal reasons briefly during the year. There’s a slight silver lining: You may still offset those gains with capital losses from elsewhere in the same year.

Thinking of converting a second home into your main residence? You may be eligible for partial exclusion — but only for the time period when the property served as your principal residence. Any gains from the time it was used as a rental or an investment property won’t qualify for exclusion.

Consider installment sales to manage the tax burden

One way to reduce your capital gains tax liability is by using an installment sale. Rather than receiving the entire profit up front, payments are spread out over a set term.

This breaks the gain into smaller taxable amounts — which can lower the overall tax burden compared to a lump-sum payout. The duration of ownership still determines whether those gains are taxed as short or long term.

Final thoughts

This is a high-level overview — and capital gains from real estate sales can be complicated, especially when large amounts of money are involved.

Work with a tax professional who understands your specific situation and can help you structure the sale the right way.