How Can We Reduce or Avoid Capital Gains on $550k From Downsizing?

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Selling your home to downsize can make your retirement more financially stable, but if you have a profit on the sale you might owe capital gains taxes. Fortunately, in many cases those selling their primary residence who are single can exclude $250,000 from capital gains taxes, while married couples filing jointly can exclude $500,000. Employing this exclusion can reduce or eliminate capital gains taxes since earnings are unlikely to go beyond those figures, if at all. Some restrictions do apply, however, so it’s best not to assume your gain will be excluded. There are other strategies that you might be able to use, but these may have significant limitations, uncertainties and risks.

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Selling your primary residence may result in capital gains taxes, but for many people it doesn’t. To determine whether your gain will get taxed, you must first figure out how much gain qualifies to be excluded. The amount of the gain that can be shielded from taxes depends on the filing status you choose when you submit your income tax return.

Single filers can exclude $250,000 and married couples filing jointly can exclude $500,000 of profits on the sale of a primary home. However, to qualify for these exclusions, the sellers must have owned and lived in the home at least two of the five years prior to selling. Also, you can’t have used the exclusion in the previous two years.

If your gain exceeds the exclusion, the amount of the overage will be taxed as capital gains. The amount of tax depends on how long you have owned the home. If you have owned it for more than a year, you’ll likely qualify for long-term capital gains tax rates of 0%, 15% or 20%. The exact rate depends on your income and other capital gains for the year, and the gain on your home sale gets included when figuring that. In this case, a married couple who makes $550,000 in gains on their home sale would likely be subject to the 15% long-term tax bracket, which starts at $48,351 for single filers in 2025.

Here’s how this all could play out, looking at three possible scenarios with some assumptions for simplicity:

1. A married couple filing jointly can exclude $500,000 in gains from taxation after the sale. This would leave only $50,000 to be taxed. Because the couple has owned and lived in the home for at least two out of the last five years, long-term capital gains tax rates will apply. The tax bill for the sale alone would be $50,000 at 15%, or $7,500.

2. If you aren’t eligible for any exclusion, due to not living in the home two of the previous five years or using the exclusion more recently than two years, then the entire $550,000 will be taxed. If the whole gain of $550,000 is taxed at 15%, the bill would be $82,500.

3. For the sake of an example, let’s assume you were single and meet the criteria for the exclusion. In this scenario, you can exclude $250,000 of the $550,000 gain, which leaves $300,000 taxable. The rate will likely be 15%, as the 20% long-term tax bracket starts at $533,401 annual income for 2025. This will result in 15% taxes owed on the $300,000, or $45,000.

While these guidelines apply to federal capital gains taxes, some states also levy capital gains taxes. States tax capital gains in a variety of ways, so you need to check local laws to get an accurate idea of your tax bill.

You may be able to reduce your taxes, even if none or only part of the gain qualifies for an exclusion. This can be done by making sure you accurately figure your cost basis of the house. To do this, add up all the improvements you made to the property. Now add this figure to the property’s original cost and subtract it from the sale price.

If you have previously not fully accounted for your cost basis, this can reduce the amount of the gain and the subsequent taxes you’ll owe. For instance, if you spent $50,000 on a kitchen renovation and hadn’t included that in your cost basis, accounting for it correctly could reduce your $550,000 gain to $500,000.

Another way to potentially defer taxes is by using the gain to acquire a new residence through a like-kind exchange. This delays tax liability until you sell the replacement home. Many limitations and risks accompany these types of deals, however. For example, if you downsize to a less expensive home, the difference in the sale price of your former residence and the price of the new property could be taxable, among other complications.

A home seller pocketing $550,000 can legally avoid some capital gains taxes through an exemption and other legitimate tax minimization strategies. However, limitations are abound, so consult a financial advisor to understand how these situations work and how to plan for them.

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The post We’re Selling Our House and Netting $550k to Downsize for Retirement. How Can We Avoid Capital Gains Taxes? appeared first on SmartReads by SmartAsset.