Understanding Tax Rules on Home Sales

Dear Liz: I thought I had a grasp on the tax implications of selling a home, but now I’m feeling a bit lost.

Previously, there were rules allowing profits from home sales to be rolled into the purchase of another home, with a one-time exemption for up to $500,000. Capital gains were only taxed on profits exceeding that limit.

Now, it seems that each sale’s gains are calculated individually, but it’s still based on purchase prices and improvements. Or is it?

Answer: You’re not alone in your confusion. A lot of people tend to remember the older rules, thinking they still apply.

The fundamental method of calculating capital gains hasn’t changed. Essentially, the homeowner’s tax basis (what they paid for the home plus any qualifying improvements) is subtracted from the net sales price to figure out any taxable gains.

Before the 1997 Taxpayer Relief Act, homeowners could defer capital gains when buying a replacement home of equal or higher value. Plus, at age 55, they had a one-time exemption that protected $125,000 of profit from taxes. This often allowed people to downsize without facing hefty tax bills, especially since median home prices back in 1997 were under $150,000.

Today’s landscape is different. Sellers can exclude capital gains of up to $250,000, or $500,000 for married couples, as long as they’ve owned and lived in the home for at least two years before selling.

However, this exclusion has remained the same since 1997, while median home prices in the U.S. have surpassed $400,000. In some areas, entry-level homes now exceed $1 million. Consequently, many longtime homeowners finding their way to the market are encountering capital gains taxes.