The sale of a personal residence can result in significant capital gains, especially for homeowners who have enjoyed substantial long-term appreciation in housing prices. Given preferential tax treatment for decades, the federal capital gains tax exclusion for home sales was capped at $500,000 for married couples and $250,000 for single filers. While generous, the exclusion is not indexed for inflation and penalizes singles. Moreover, the value of the exclusion has been diminished by the rapid rise in housing prices.
To benefit from the home sale exclusion, the taxpayer must have lived in their home for at least two years within the last five (the use test) and must have owned their home for two years in the last five (the ownership test). If your capital gain exceeds your qualified home sale exclusion, you will have a taxable capital gain.
Capital gains on homes, and other capital assets, held at least one year are taxed at preferential long-term capital gains rates of 15% and 20% based on your filing status and taxable income. In addition, the 3.8% net investment income tax applies to single taxpayers with adjusted gross income exceeding $200,000 and married taxpayers with adjusted gross income exceeding $250,000. Capital gains tax and the net investment income tax only apply to gains over the $250,000 and $500,000 exclusion thresholds.
When a taxpayer sells their home, the net sale price that exceeds the original cost plus any home improvements results in a capital gain. Homeowners need to maintain meticulous records to distinguish home improvements from home repairs. Improvements are added to the cost basis and help reduce one’s capital gain and potential tax liability, while home repairs are not added to basis and offer no relief. Real estate commission and other transaction expenses reduce the net sale price and therefore reduce your capital gain exposure.
According to a report by the Congressional Research Service, “given concerns about recently rising housing prices and inflation in general, some policymakers may reconsider the $250,000/$500,000 cap.” The report also notes “If the $250,000 and $500,000 values had been increased to reflect the change in the average housing price between 1998 and 2025, they would now be approximately $720,000 and $1,440,000, respectively.”
Some taxpayers intentionally own their home until death and leave it to heirs who benefit from a step-up-in basis, increasing the cost basis of the home to the date of death fair market value effectively eliminating any capital gain on the home appreciation that occurred during the original owner’s lifetime. If a homeowner gifts their home to an heir during life and the home has appreciated since purchase, the gift recipient’s basis will equal the donor homeowner’s basis just before the donor homeowner made the gift.
While California does generally conform to the IRS rules allowing eligible taxpayers to utilize the federal home sale exclusion, not all states assess a state-level long-term capital gains tax or an income tax, so a state level capital gain on the sale of your home would not be relevant in certain states.
For taxpayers who own rental property but desire to use the rental property as a personal residence, the capital gains exclusion can be utilized if the rental property is converted to a personal residence and used as such for at least two of the previous five years. In addition, a taxpayer that owns a rental property can combine a like-kind exchange of the rental property for a residential property, then use the residential property as their personal residence, and exclude capital gains up to the allowable amount as long as they meet the ownership and use tests over a minimum of five years before the sale of the property. However, you may not exclude the portion of your gain resulting from depreciation deductions taken on the rental property.
Vantage Wealth cannot give tax advice, and we recommend that you consult with your CPA regarding your eligibility for the home sale exclusion on a potential home sale.