When you sell your house, Uncle Sam may be entitled to some of the money. What you use the proceeds for, such as paying off your current mortgage, doesn't matter to the Internal Revenue Service. Even if you use every last penny you get from the sale to pay off your mortgage, you might still owe taxes.
TL;DR (Too Long; Didn't Read)
You may be responsible to pay capital gains taxes after you sell your home. Paying off your mortgage doesn't play into account.
Calculating Your Gain
Your taxable gain from selling your home equals the amount realized on the sale minus your adjusted basis. Your amount realized is the selling price minus any selling expenses, like those pesky broker's fees. Your adjusted basis in the home is the amount you paid for it, plus any improvements you made, minus any depreciation expenses you deducted if you rented out the house or used it for business. For example, if you paid $300,000 to buy the home, paid $50,000 for improvements, and took $10,000 in depreciation, your adjusted basis would be $340,000. When you sell the home for $385,000 and pay your broker $5,000, your gain is $40,000.
Primary Residence Exclusion
The IRS lets you to exclude up to $250,000 of home sale gain if you've both owned and used the home as your primary residence for two of the past five years. The years of ownership and the years of don't have to be consecutive, or even the same years. For example, if you rent the home for a year, buy it, live in it for another year, you satisfy the use test. If you move out but wait another year before selling, you meet the ownership test. In addition, you can't claim the exclusion if you have used it within the past two years.
If you claim depreciation of your house as a home office, the IRS hasn't forgotten about the depreciation deductions you claimed. Depreciation deductions reduce your basis in the home. In addition, the gain due to the depreciation can't be removed from income under the home sale exclusion. For example, if you paid $150,000 to buy your home, took $10,000 of depreciation for your home office over five years, and then sold the home for $200,000, you would have $60,000 of gains. If you qualify for the exclusion, you're limited to just the $50,000 of capital gains because the $10,000 of depreciation recapture is not part of the equation.
Applicable Tax Rates
For the very lucky homeowners who managed too large a profit to exclude it all, the tax rate on your gains depends on how long you owned the home and whether you have any depreciation to recapture. First, any depreciation recapture is taxed at 25 percent because you already got your tax break for that portion of the gain. If you owned the home for a year or less, your gain is subject to ordinary income tax rates. If you owned the home for more than a year, the gain is subject to the lower capital gains tax rates. If you play your cards right, you can end up with a sizable gain that's either completely tax-free, or at least mostly subject to the lower capital gains rates.
- Internal Revenue Service: Publication 523: Selling Your Home
- Exeter: Depreciation Recapture Income Tax Rates and Guidelines
- Internal Revenue Service: Topic 409 - Capital Gains and Losses
- Investopedia: Depreciation Recapture
- Wilkin Gutten Plan CPAs & Advisors: Tax Matters: Tax Implications of “Depreciation Recapture” When Selling Real Estate
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."