Here's how to reduce your capital gains tax bill after selling a home

Despite the decline in home sales in the United States, many homeowners made profits from the sale of properties in 2023. Experts say those gains could lead to a tax bill this season, depending on the size of the windfall.

In 2023, home sellers made a profit of $121,000 on the typical median-priced single-family home, according to ATTOM, a nationwide real estate database. That's down from $122,600 in 2022

But sometimes profits exceed the IRS limits for tax-exempt gains and “it's a shock” to sellers, said certified public accountant Miklos Ringbauer, founder of MiklosCPA in Los Angeles.

However, “tax laws are designed to encourage homeownership,” and many sellers qualify for a tax break, Ringbauer said. a

Single homeowners can shield up to $250,000 in home sales profits from capital gains taxes, and married couples filing jointly can exclude up to $500,000, provided they meet IRS eligibility.

If you own the property for more than one year, gains over $250,000 and $500,000 are subject to long-term capital gains taxes, which are levied at 0%, 15%, or 20%, depending on your 2023 taxable income. ( You calculate your “taxable income” by subtracting the greater of your standard or itemized deductions from your adjusted gross income.)

Ringbauer cautioned that there are strict rules to qualify for the $250,000 or $500,000 capital gains exceptions.

The “ownership test” states that you must own the home for at least two of the last five years before selling your home — but this is only required for one spouse if you are married and filing jointly.

There is also a “residence test,” which requires that the home be your primary residence for 24 months of the five years prior to the sale, with some exceptions. (The 24-month residency period can fall anywhere within the five-year period, and does not have to be a single time period.)

Both spouses must meet the residency requirement for complete exclusion.

A partial exclusion may also be possible if you sell your home because of a change in business location, health reasons or “unforeseen events,” according to the IRS.

Generally, you cannot get the tax break if you get the exception for selling another home within two years of the closing date.

If your capital gains exceed the IRS exclusions, it's possible to reduce your gains by increasing your home's original purchase price, or “basis,” according to certified financial planner Assunta McLean, managing director of Summit Place Financial Advisors in Summit, New Jersey.

You can increase your home's basis by adding certain improvements you've made to the property to “extend its useful life,” according to the IRS.

For example, you could address the cost of home additions, updated systems, landscaping, or new appliances. But the cost of repairs and maintenance is generally not accounted for.

Of course, you'll need detailed records to show evidence of capital improvements, because “estimates don't work when it comes to auditing,” Ringbauer said.

After the home is sold, the IRS receives a copy of Form 1099-S, which shows the closing date and total proceeds. But you need paperwork to prove any changes to your home's foundation.

Failing to keep home improvement records throughout the life of ownership is a “common mistake,” McLean said.