Could you face a tax bill on your home sale?

While the housing market has undoubtedly slowed in the past year, prices in many areas are still elevated after the strong run-up over 2020 to 2022.

All that accumulated appreciation has been a boon for owners' net worths. But it also means that more and more owners may need to anticipate a capital gains tax bill when they eventually sell.

"Growth in the value of your property means you'll make more if you sell it—and that means you might owe more," says Meredith Stoddard, Fidelity life events experience lead.

Could you owe capital gains tax on your home?

Some people may be surprised to learn that it's even possible to owe capital gains tax on their home. That's because there's an exclusion on gains from the sale of a primary residence, which generally lets sellers exclude up to $250,000 in gains from their income (or $500,000 for certain married taxpayers filing a joint return and certain surviving spouses).¹

While those amounts have been generous enough in the past that even long-time homeowners could potentially sell without a tax consequence, the dramatic run-up in prices in recent years may have more sellers bumping up against the exclusion limits. (The current exclusion amounts have been in place for more than 25 years, and were adopted in the Taxpayer Relief Act of 1997.²)

The exclusion is intended to apply to the home you live in, not investment properties, so to qualify for it you must meet the IRS's ownership and use tests. The exclusion rule generally allows a taxpayer to exclude from gross income gain realized from the sale or exchange of property if, during the 5-year period ending on the date of the sale or exchange, the property has been owned and used by the taxpayer as the taxpayer's principal residence for a period totaling 2 or more years. The exclusion is allowed each time a taxpayer meets the eligibility requirements, but generally no more often than once every 2 years.³ There are no income limitations, and an owner may rent or use the property as a non-primary residence following the period of primary residency without consequence up to the end of the 5-year period, and still claim the exclusion.

How much capital gains tax could you owe?

If you do have to pay capital gains tax, how much you owe will depend on how long you owned the house, your filing status, and your income.

Selling a house you've owned for 1 year or less generates the steepest potential tax rate. In that case you don't qualify for the exclusion and gains are considered short term, meaning they'll be taxed at federal ordinary income rates, which can run as high as 37%. If you've owned the home for more than 1 year but less than 2, then you still don't qualify for the exclusion, but you may pay the lower, long-term federal capital gains rates on gains.

In addition to federal income or capital-gains tax, state taxes and the 3.8% Net Investment Income Tax may apply. If you rented the property at any point and claimed depreciation, you may be subject to depreciation recapture at federal ordinary income rates up to a maximum of 25%. You do not have to pay taxes on any amount of the sale proceeds below your adjusted basis (more on that below).

(Learn more about ordinary income tax rates and strategies for managing capital gains tax exposure.)

Ways to potentially reduce capital gains tax on home

Calculating your gain is more complicated than simply taking the sale price and subtracting your original purchase price. Instead of selling price, taxes will be based on the "amount realized" on the sale, which accounts for many selling expenses.⁴ And instead of original purchase price, sellers subtract their "adjusted basis," which factors in the purchase price, but also certain purchase expenses and the cost of any improvements made to the home over the years.⁵

Altogether, this means there are potentially 3 stages along the way of the homeownership journey when it makes sense to keep track of relevant expenses.

Even if you have no plans to sell anytime soon, try to keep track of money you put into your home, particularly if you're going through any major remodeling or renovations.

To ensure you have the proof you need to get this adjustment, make sure to keep detailed records of the dates and descriptions of any improvements, as well as the companies that performed the work and your paid invoices. "It can be helpful to keep copies of permits, blueprints, and photos, even though they're not required," adds Stoddard. "The important thing is to keep your records organized, so another person could make sense of them if you ever need to provide proof of your improvements."

Be aware that gain from the sale or exchange of a principal residence allocated to periods of nonqualified use (such as use as a second home, vacation home, or rental property) is not excluded from gross income and you may only be allowed to claim a portion of the exclusion.⁷ The portion of gain from the sale of property attributable to depreciation after May 6, 1997, is not eligible for the exclusion.⁸

A tax professional can help you better understand your personal situation—not only in terms of working out your adjusted cost basis, but also in understanding the impact of any gains on your taxes.

Offsetting capital gains with losses

Homeowners may also be surprised to learn that they can potentially offset capital gains on their home with realized capital losses on securities or other assets. This may be possible if you sell other assets at a loss in the same year you sell your home, or if you have losses from previous years that you've carried forward for tax purposes. If you're considering pursuing tax-loss harvesting by selling securities, just be mindful of any potential for wash sales and make sure not to throw off your investment plan. Consider working with a financial professional to identify a tax-loss harvesting strategy that's consistent with your long-term investment goals.