As the Real Estate Market Booms, Higher Prices Increase Your Capital Gains

A lot of consideration is often given to the home buying process. Attention is showered by Realtors, lenders and even glamorized on television shows. I’m interested in the other side of the transaction. How will you know if you’ll owe tax on the appreciation of your home after you have sold it?

You can sell your primary residence and will avoid capital gains tax on the first $500,000 of appreciation if you’re a married, filing jointly taxpayer (the exemption is $250,000 if you’re a single tax filer). This sounds great, however, there are a couple of caveats that should be clarified.

  1. This exemption applies to your primary residence, as defined by the Internal Revenue Service: You must have occupied the residence for at least two of the past five years. Those two years do not need to be consecutive. But if you’re planning to sell a property, it may make sense to make sure you pass the IRS definition of primary residence, particularly if that property has highly appreciated. 
  2. Another restriction is that the IRS only allows this exemption once every two years. So if you’re flipping houses every year, you’re likely paying capital gains tax on the appreciation. 

​For example, if a married couple sells their primary residence, as defined by the IRS, for $600,000, which they bought for $100,000 three years earlier, no tax would be owed, as the first $500,000 of gain is exempt. 

​But what would happen if the same couple above sold the house for $700,000 for a gain of $600,000? The first $500,000 is still exempt from capital gains tax and $100,000 will be subject to capital gains tax depending on their income level and capital gains bracket. The holding period in this example is longer than a year, so long-term capital gains rates would apply. 

​The IRS does allow the cost of improvements to be added to cost basis. This would allow for the upward adjustment to cost basis, which would ultimately decrease the appreciation of the property and likewise decrease the amount to which capital gains tax would be owed. That $100,000 in appreciation, above the $500,000 exclusion, could be decreased by various fees and improvements that were applied to the house, so save the receiptsfor the new roof and windows!

​If multiple properties are owned, it makes sense to consider ways to minimize tax. Perhaps the second house is a rental — by using it as your principal residence for two years within a five-year period, you could exempt all, or a portion, of the gain potentially subject to tax. In an extreme example: Over a five-year period, if the home is your principal residence in year 1, then it’s rented for the next three years, then finally declared again as your primary residence in year 5 the tax exemption would apply, assuming you did not use the exemption within the last two years. 

​The takeaway here is: If you’re using a home as a primary residence, there is a good chance you can eliminate or minimize the capital gains tax owed. If you have a second home you’re looking to sell, which has appreciated, if may make sense to use that property as a primary residence, as defined above by the IRS, to avoid tax on the appreciation. If in doubt, speak with a tax professional. When the stakes are high, it never hurts to have a second set of eyes reviewing the situation.

Matt Mondoux sits on the investment committee and is an adviser at Blue Chip Partners, Inc., a privately owned, registered investment advi­sory firm based in Farmington Hills, Michigan. Visit

This article was originally published in the August 2021 issue of BetterInvesting Magazine.

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