How Much Will You Owe in Capital Gains Taxes
When You Sell Your Home?

Good Morning Relaxing Retirement Member,

A few of our Relaxing Retirement members are in various stages of selling their primary homes right now, and each of them has inquired about capital gains taxes they will owe.

As you might imagine, I see this a lot.  When you were younger and you had a family, having a lot of space in your home was very important: multiple bedrooms and bathrooms, a finished basement, a big yard, etc.

However, now that the kids are out on their own and you have transitioned to the next phase of your life, your big house, and all the physical responsibility that comes along with it, is not as appealing as it once was.

Should you sell your home and move into an arrangement that is more suitable to your current lifestyle?  In each situation, in addition to all the time that went into finding a more suitable living situation, a grey area for them was the tax implication of selling vs. keeping their home and passing it on to their children.

I thought it would be a good idea to share the brief case study I provided each of them to clarify what they can anticipate in their respective situations.

John and Carol

Let’s assume for a moment that we have a couple, John and Carol, who are now 66 years old, and they have three children, all of whom are married.

John and Carol purchased the home that they now live in back in 1980 for $300,000.  Back then, it seemed like all the money in the world, but it was worth it because it was a great house in a family neighborhood.

Right before they retired, they paid off their mortgage in full which included a second mortgage that they had taken out to help with college tuitions.

Today, because they purchased their home in a very nice town, they’ve been told by a local realtor that their home is currently worth $1,350,000.

Hard to believe, but this is what has happened to housing prices in our area.

Tax Implications

If John and Carol decide to sell their home right now, what are the tax implications?

What if they keep their home and the kids inherit it?

To understand what the implications will be, you have to become familiar with the term “cost basis”.

Cost basis is a “tax” term which equals your total cost in an asset like a home.

In John and Carol’s case, this starts with their purchase price: $300,000.

If they made permanent home improvements over the last 35 years, this would add to their cost basis.

In this case, let’s assume that John and Carol made $250,000 worth of improvements over the years, including a big addition, finishing 1,500 square feet of their basement, and a swimming pool.

This now brings their cost basis up to $550,000 ($300,000 original purchase plus $250,000 in improvements).

If John and Carol sell their home and walk away with $1,265,000 (after paying their real estate broker and closing costs), they may exclude their “cost basis” or $550,000 from capital gains taxes, thus leaving $715,000 subject to capital gains tax.

Capital Gains Tax Exclusion

Several years back, Congress passed a law that allows individuals to exclude $250,000 from the proceeds of the sale of your home, or a combined $500,000 if you’re married and own the property jointly.

So, in addition to being able to exclude their cost basis from taxes, John and Carol may also exclude another $500,000.

To summarize, if they sell their home for $1,350,000, pay their realtor and closing costs and walk away with $1,265,000, $1,050,000 is NOT subject to capital gains taxes.

To arrive at $1,050,000, we take their cost basis of $550,000 (purchase price and permanent home improvements), and their federal primary home sale capital gains exclusion of $500,000.

$215,000 (the difference) is then subject to capital gains taxes which are currently either 15% or 20% on the federal level.  And, at higher income levels with the medicare surtax, add another 3.8% if your income on your tax return is above $250,000.  And, if you happen to live in Massachusetts, add another 5% tax.

In John and Carol’s case, assuming their other income placed them in the 20% capital gains tax bracket, they’d owe approximately $43,000 in federal capital gains taxes if they sold their home today.

Step-Up in Basis

However, this changes if John and Carol decide to keep their home and pass it to their children at their death.

When you pass away, the cost basis in all your assets “steps up” to your date of death value!

This is significant.

In John and Carol’s case, if the value of their home at their deaths was $1,350,000, and their children sell their home soon after their deaths, $1,350,000 is excluded from the sales price as far as capital gains taxes are concerned.

In other words, the kids would pay no capital gains taxes if they sold their house for that same amount.

That’s a $43,000 difference!

As a side note, if the kids keep the house for a few years and later sell it for $1,500,000, they’d owe capital gains tax on the growth since the date of their parents’ death, or $150,000.

The Lesson

The lesson in this Strategy of the Week is to know your cost basis in all your assets (your home, your investments, your business, etc.), and have as much supporting documentation as possible.

When you know your cost basis, you can make calm, rational decisions based on fact.  And, that’s how you want to make all your decisions.

If you’re having a tough time calculating your cost basis, let us know so we can help you.

Committed To Your Relaxing Retirement,

Jack Phelps
The Retirement Coach

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(The content of this letter does not constitute a tax opinion. Always consult with a competent tax professional service provider for advice on tax matters specific to your situation.)