In recent years, the residential real estate markets in many areas have surged. That means there are more seniors with highly appreciated homes than ever before. If you’re facing this situation, you might be rightfully concerned about the potential tax hit on the sale. Here’s a tax-saving strategy to consider.

Home Sale Tax Basics

If you sell a highly appreciated principal residence, your profit could potentially exceed the federal home sale gain exclusion. That means part of the profit will be taxed as capital gain (unless you have offsetting capital losses). The maximum gain exclusion is $250,000 for single taxpayers ($500,000 for married couples who file jointly).

For example, Al and Stephanie bought their home many years ago for $300,000. After making various improvements, their tax basis in the property is $500,000. They sell it for a net sales price of $3 million. So, their tax return for the year would show a taxable gain of $2 million ($3 million minus $500,000 of tax basis minus the $500,000 gain exclusion).

How much tax would this hypothetical couple owe on their large taxable gain? The answer depends on the applicable tax rate.

Federal Capital Gains Tax Rates

Taxable gain from a home sale will generally be taxed at the favorable long-term capital gain (LTCG) rates if you’ve owned the property for more than one year. Under the current rules, the maximum LTCG tax rate is 20%.

Here are the 2024 federal rate brackets for net LTCGs, based on taxable income, including any LTCGs:

Important: If you live in a state with no personal income tax, you’ll only have to worry about the federal tax hit. However, most states that assess personal income tax will tax capital gains, including taxable home sale gains, at the same rates as ordinary income. State and local income tax rates vary, and the tax bill can be substantial, especially if you live in a high-tax jurisdiction (such as California or New York City).

Net Investment Income Tax

Some home sellers also may be exposed to the 3.8% net investment income tax (NIIT). The NIIT hits the lesser of your:

• Net investment income, including capital gains and dividends, or
• The amount by which your modified adjusted gross income exceeds the applicable threshold.

The thresholds are as follows:

• $200,000 for single taxpayers and heads of households,
• $250,000 for married couples who file jointly, and
• $125,000 for married couples who file separately.

So, some home sellers could owe up to 23.8% to Uncle Sam on long-term gains from home sales (20% LTCG tax plus 3.8% NIIT).

Tax Rate on Gains Attributable to Depreciation Deductions 

If part of your gain is taxable due to business or rental use of the home, you also must file Form 4797, “Sales of Business Property.” That form calculates how much of your gain may be subject to the special 25% federal income tax rate on gain attributable to depreciation deductions. These are technically called “unrecaptured Section 1250 gains.”

Possible Solution: Aging in Place

Instead of selling your highly appreciated home, you could choose to hang on to the home to avoid a painful tax hit. If you’re able to keep the home until you die, for federal income tax purposes, the tax basis of the portion of a personal residence that you own is stepped up to fair market value (FMV) on either:

• The date of your death, or
• Six months after that date, if the executor of your estate chooses the alternate date.

If you’re the sole owner of your home, the basis step-up rule applies to the entire residence after you die. When your heirs sell the property, federal capital gains tax will only be due on the additional appreciation (if any) that occurs after that date.

If you own the home with your spouse, the tax basis of the portion you own will be stepped up when you die. The tax basis of the remaining portion will be stepped up when your spouse dies. Once again, your heirs will probably owe little or no federal capital gains tax when the property is sold.

If you and your spouse own the home as community property in one of the nine community property states, the tax basis of the entire residence is generally stepped up to FMV when the first spouse dies, not just the half that was owned by that person. This means the surviving spouse can then sell the place and owe little or nothing in federal capital gains tax.

Important: If these taxpayer-friendly basis step-up rules also apply in your state, the aging-in-place strategy will work for state income tax purposes, too.

Vacation Homes

If you sell a highly appreciated home that’s not your principal residence — such as a vacation home — you get no gain exclusion break. So, the entire profit will be taxed as capital gain (unless you have some offsetting capital losses).

Going back to the previous example, let’s assume the same facts, except that Al and Stephanie sell a vacation condo in Florida, rather than their personal residence. In this situation, the couple would have a taxable gain of $2.5 million ($3 million minus $500,000 of tax basis in the property). There’s no gain exclusion break for vacation homes.

However, if you hold on to a highly appreciated vacation home until you die, your heirs will receive a step-up in basis on the home. The stepped-up basis will equal the property’s market value on the date of your death (or its market value six months after the date of your death if your executor elects to use an “alternate valuation” date). Then, if your heirs decide to sell the property, they’ll only pay capital gains tax on the difference between the net sales price and the stepped-up basis. This strategy could save major tax dollars compared to selling the property during your lifetime.

When It Might Pay to Do Nothing

Tax planning usually calls for you to take action. But this is one situation where it might make sense to hang tight. If you’re worried that you can’t afford to keep your home, you can probably take out a reverse mortgage to get the cash you need. The interest and transaction costs of a reverse mortgage could be a small fraction of the tax cost you’d avoid by hanging on to your highly appreciated home. Contact your tax advisor to determine if this strategy is right for you and your family.