Is There a Tax Penalty for Selling a House Before 2 Years?

The PropertyClub Team
Jun 9th 2020
If you are thinking of selling a home you've owned for less than 2 years, you might be wondering what the tax implications are and if there are any penalties. Learn about how to avoid capital gains on your primary residences in this comprehensive guide.

If you do find yourself in a situation where you need to sell before two years of ownership, then there are some important aspects of trying to sell your home that you need to be aware of before taking the plunge. There are several reasons to try to avoid selling too soon if you can. Not only are there tax implications of selling a home that you haven’t owned for long, but there are also considerations to be made regarding mortgage payments and equity.

To be clear, you can legally sell your home at any time that you want, because the property belongs to you, it is yours to put on the market if you decide to. However, it should be noted that selling a home before you have owned it for 2 years is inadvisable if you have a choice. The primary reason for this is that, unless your property has somehow appreciated tremendously in value very quickly, you likely don’t have enough equity to cover the costs of selling the home within such a short amount of time after buying.

When you first start making mortgage payments, the money usually goes to paying off interest first, before it even touches the loan payments you are making on the property. Because of this, it can take years to build up equity on a house, even though you’ve been religiously making those monthly payments. This can be confusing to people, as they have the impression that they’ve been paying down their mortgage and building equity when most of what they have been paying for the first few years is interest. 

Another consideration is that it’s not cheap to list a house for sale. There are listing and agent fees to be considered. If you haven’t owned the home for long or if your property hasn’t appreciated drastically in value, these can quickly counteract any equity that you have managed to gain. Essentially, if you have owned a home for less than 2 years, it’s likely going to cost you more to sell than it did to buy, and you’ll end up losing money.

How long do you have to live in your house to avoid capital gains tax?

If none of the above points discourage you from selling too quickly, or if you don’t have a choice but to sell, then the next important consideration is the tax implications of selling a home before the two-year mark. This is where Capital Gains Tax comes into play. 

You don’t just automatically get to keep any profits you make on your home without the IRS taking a piece of the action, which is why those who don’t consider the tax implications of selling a home can be in for a nasty surprise.

What is Capital Gains Tax?

To many people, the term “capital gains tax” brings with it a dreaded feeling. Oftentimes, we understand that capital gains tax is something to avoid wherever possible, but don’t fully know what the term means. Nobody wants to get stuck in a situation where they unexpectedly owe huge amounts of money to the IRS, which is why so many people want an answer to the question; how long do you have to live in your house to avoid capital gains tax? 

The best way to understand why there are limitations on how long you need to live in a home is to first fully comprehend exactly what capital gains tax is. From there, it’s easier to learn how to avoid paying it if you don’t have to.

A “capital gain” is when you sell an asset for more than you originally paid for it. In most cases, you have to hold an investment for longer than a year for it to be considered a long-term gain, and the investment is then taxed at a lower rate. This is where the issue comes in with selling a property before the two-year mark. If you turn around and sell really quickly, the property will be taxed at a considerably higher rate, as it is considered a short-term gain. Most importantly, if you sell a property that you didn’t live in for at least 2 years, any profit or gain that you make on the home is then considered taxable by the IRS. 

How long do you have to live in your primary residence to avoid capital gains?

The IRS allows you to exclude up to $250,000 of capital gains on real estate if you are single and up to $500,000 if you’re married. But, and here’s the big BUT, this does not apply if you sell the home before you have owned it and lived in it as a primary residence for two years. 

Therefore, if you find yourself selling a home before living in it for 2 years you should be aware that whatever amount of profit you gain on the sale of your house is subject to capital gains tax. 

Because of this, if you need to sell in order to relocate or for other unavoidable reasons, it’s often advisable that you consider renting out your property or using it as an AirBnB until the two-year mark is up. This will allow you to continue to build up equity in the home. 

How much capital gains tax can you expect to pay?

The amount of tax you can expect to pay changes depending on the length of time you own a property. As mentioned above, if you sell before you have maintained ownership for one year, you will be taxed at a short-term rate, which is equivalent to your income tax rate. If you sell after more than one year, you will then be taxed at a rate of 20%.

Remember, if you sell after two years of ownership, up to $250,000 of those gains ($500,000 if married and filing jointly) is not taxable

Here is a simplified example:

Say you are single, you bought your home for $300,000 and sold it three years later for $600,000. You have made $300,000 in profit.

$250,000 of that profit is not taxable by the IRS (because of the length of time you owned the home for), but the remaining $50,000 is taxable at a rate of 20%.

How long do you have to buy a house to avoid capital gains taxes?

So, we now know that if you sell too quickly, you can be subject to paying exorbitant amounts in taxes. But what about buying a new home? In the past, the regulations were that, once you sold your home, you had to buy a replacement home that cost more than the amount you received for the home you sold. 

However, the Taxpayer Relief Act of 1997 did away with these regulations. This means that you can exclude up to $250,000 of profits on your home’s sale (or $500,000 if married), and there are no longer any additional requirements that obligate you to purchase a new home. 

Capital Gains Tax on Real Estate Investment Property

Most homeowners don’t find themselves in a situation where they have to sell very quickly, which is why the issues of taxes more often apply to investors or those who are trying to flip houses for a profit. In these situations, you can potentially avoid paying capital gains tax by filing a 1031 exchange. This allows the “swap of one investment property for another that allows capital gains tax to be deferred.” The properties must be considered “like-kind in the eyes of the IRS,” and you must close on the new property within 180 days of selling the previous one. However, if used correctly, there is no limit on the number of times an investor can swap properties using a 1031 exchange. 

All in all, being educated on the tax implications of selling a home in under two years is vitally important to ensure that you don’t get stuck paying taxes you were not expecting. If it’s possible to avoid this scenario and hold on to your property, that is the most advisable outcome. Otherwise, there’s unfortunately really no way for a homeowner to avoid paying capital gains tax.