Selling Your House and Buying Another: How Capital Gains Work

When you sell your house and buy another, capital gains are the profits that you make from your sale, and these are subject to capital gains tax. However, if your new home purchase doesn’t impact your capital gains, the exclusions available could allow you to reduce your tax liability. If your sale is conducted properly and your living arrangements meet the criteria, you can avoid capital gains tax all together. 

Here's a Breakdown of How Capital Gains Work When Selling Your House and Buying Another

Each homeowner can exclude up to $250,000 in capital gains on a sale of a home, assuming certain criteria are met. Married taxpayers filing their taxes jointly can exclude up to $500,000. Additionally, capital gains are reduced by costs of home projects that build equity, or expenses paid at the purchase or sale of a house. It is important to understand the capital gains calculation process so you can record these expenses properly and avoid unnecessary taxes. 

Can You Qualify for the Capital Gains Tax Exclusion?

Before making any calculations, you must first qualify for the capital gains exclusion. This requires satisfying three criteria: 

1. You have lived in the home at least two years. If you sell your home and buy another, the capital gains exclusion requires you to have lived in the first home for at least two years of the five years prior to the sale.
2. The home is your primary residence. For at least two of the five years before the sale, you or your spouse must have used the home as your primary residence.
3. Other capital gains exclusions were made more than two years ago. If you have used the capital gains exclusion before, it must have been more than two years ago.

How to Calculate Capital Gains When Selling a House and Buying Another

Before 1997, different methods were used to calculate capital gains taxes, and one home sale was impacted by a new home purchase. Currently, the tax implications of each home are calculated separately. This means that when you sell your house and buy another, capital gains are calculated only using the sale and purchase price of the first house. 

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Capital gains are calculated using the following method: The sale price of your home minus what you paid for it, other purchase costs, improvements you made, selling costs, and some insurance payments. In other words, the capital gains are the total net profits you made from the home after deducting expenses related to improving, buying, and selling the home. 

Capital Gains Tax Exclusion Example

Let's say you purchase your first home for $100,000. At that time, you pay closing costs totaling $3,000. While you own the house, you renovate the kitchen, bathroom, and finish the basement, totaling $50,000 in expenses. Thanks to your home upgrades, you’re able to sell the house for $250,000. Your selling costs amount to $2,000. You can calculate your capital gains as follows:

$250,000 – ($100,000 + $3,000 + $50,000 + $2,000) = $95,000

As a single person who owned and lived in the house for at least two years in the five years prior to sale, you can exclude up to $250,000 of capital gains. This means that your $95,000 capital gains do not have to be reported, and you will not pay taxes on it. Keep in mind that when you sell your house and buy another, capital gains will be calculated separately on the new house when you sell it.

If your total capital gains exceed the exclusion amount, you will have to pay capital gains taxes at a rate decided by your income. When calculating your capital gains, be sure to diligently record investments you’ve put into the home as well as expenses incurred when you bought and sold the property. If you’re not sure what these expenses are or how to calculate your capital gains taxes, ask your realtor to help you or refer you to a property tax expert who can help.