Do you pay capital gains tax when you sell your home in Arizona?

For most people selling the home they actually live in, the answer is no. Not because of a loophole, and not because of anything clever. Because of a single line in the federal tax code that exists for exactly this situation.

I'm Jen Keene, a REALTOR® in Scottsdale, AZ helping long-time homeowners sell the family home and find the next one. This is the first question almost every seller asks me, usually before the second sentence of the conversation, and it's a reasonable place to start. If you bought in 2003 and the house has tripled, the gain on paper is large enough to be frightening.

Here is the short version, and then I'll walk you through exactly how it works. A married couple filing jointly can exclude up to $500,000 of gain on the sale of a principal residence. A single filer can exclude up to $250,000. If your gain lands under your number, there's no federal capital gains tax on it at all, and in most cases nothing to report.

The two things that catch people are that the gain isn't what you think it's, and that the test is stricter than most people remember. Both are worth ten minutes before you list, because both are fixable in advance and neither is fixable afterwards.

One scope line before we go further, and I mean it rather than offering it as cover. I'm a licensed real estate agent, not a CPA or a tax attorney. What follows is how the rule works and what I watch for on a listing. The number on your return is your accountant's call, and on a long-held home with a real gain you want that conversation before you sign a listing agreement, not in April.

The rule is Section 121 of the federal tax code, and it has three conditions. All three, not any of them.

• You owned it for at least two of the last five years. Counted back from the closing date.
• You lived in it as your principal residence for at least two of the last five years. The two periods don't have to be the same two years, and they don't have to be continuous. Twenty-four months of living there inside the last sixty is the test.
• You haven't used the exclusion on another home in the two years before this sale. It's available once every two years, not once in a lifetime.

If you've been in the house fifteen or twenty-five years, you pass the first two without thinking about it. That's why this rarely comes up as a problem for the sellers I work with. It comes up as a problem for people in motion: a second home that was never the principal residence, a house that was rented for a stretch, a couple who sold one home eighteen months ago and are now selling another.

Two details that matter more than they look.

The exclusion is a threshold, not a proration. It isn't reduced because you owned the house for eight years instead of thirty. You either pass the two-of-five test and get your full amount, or you don't pass it and get none of it, with narrow exceptions for a move forced by a job change, a health reason, or certain unforeseeable events. Those exceptions give a partial exclusion, and they're worth asking your accountant about specifically rather than assuming.

And it applies to gain, not to proceeds. Nobody is taxed on the wire at closing. What's measured is the gain, which brings us to the part almost everyone gets wrong.

This is the single most useful thing in this article, and it's the reason a seller who thinks they have a problem often doesn't.

Your gain is what the home sold for, minus the costs of selling it, minus your adjusted basis. Your adjusted basis starts at what you paid and goes up with every capital improvement you've made since.

Improvements add to your basis. Repairs don't. The line between them is whether the work added value or extended the life of the property, or simply kept it in the condition it was already in. On a house somebody has lived in for twenty years in this climate, the improvement list is usually long and usually forgotten:

• A roof replacement, and in Scottsdale that's often two of them.
• Every HVAC replacement. On a twenty-year hold, expect at least one and often two.
• A pool, a spa, decking, or resurfacing.
• A kitchen or bathroom remodel, new flooring throughout, replacement windows, a new water heater.
• Landscape work that changed the property rather than maintained it. Hardscape, walls, irrigation systems, mature planting.
• Solar, where it was purchased rather than leased.
• An addition, a casita, a garage conversion, a permitted patio enclosure.

Painting, a service call, replacing a broken pump, cleaning: those are repairs and they don't move your basis.

The reason to care is arithmetic. A couple who paid $340,000 in 2003 and put $180,000 of real improvement into the house over two decades don't have a basis of $340,000. They have a basis of $520,000 before selling costs, and the gain they were worried about is a good deal smaller than the one they calculated in their head. On a home near the top of the exclusion, that difference is the whole question.

What that means practically is dull and it's the most valuable thing I can tell you: find the receipts. Not at closing. Now. A folder, a shoebox, a bank statement search, permit records from the city, the invoice in your email from the roofer in 2014. Every documented improvement is basis, and undocumented improvements are a conversation with your accountant about what can be reasonably substantiated.

Selling costs come off as well. The commission, title and escrow fees, recording, transfer costs, and in most cases the concessions you paid toward a buyer's closing costs. Those reduce the gain too, and they're on the settlement statement, so that part takes care of itself.

Arizona has no separate capital gains tax with its own rate. Gains are taxed as part of your ordinary income on the Arizona return, at the state's flat individual rate.

There's one Arizona feature worth knowing about, and it has an edge to it for exactly the sellers I work with. The state allows a subtraction for a portion of net long-term capital gain, and it applies to assets acquired after December 31, 2011. A home bought in 2003 was acquired before that date, so the subtraction doesn't reach the gain on it.

That sounds like bad news and usually isn't, for the reason the whole article turns on. If the federal exclusion covers your gain, there's generally no gain left for Arizona to tax either, because the state starts from your federal figure. The Arizona question becomes live in the cases where the federal exclusion doesn't cover everything: a gain above your exclusion amount, a property that wasn't your principal residence, or a stretch of years when the home was rented.

That last one deserves its own sentence. If you ever rented the house out and claimed depreciation, the depreciation you took isn't covered by the exclusion. It's recaptured and taxed, separately from the gain itself, and it surprises people who rented a house for three years a decade ago and forgot it happened. If that's your situation, it's a specific question for your accountant with the old returns in front of you.

In order of how often I see them.

No record of twenty years of improvements. The most common and the most expensive. The work was done, the value is real, and the receipts are gone, so the basis defaults to the purchase price and the gain is overstated on paper. Nobody can fix this after closing. The time to assemble it's while you're still in the house with access to your own filing cabinet.

Selling in the wrong order after losing a spouse. A surviving spouse may be able to use the $500,000 amount rather than $250,000 if the sale happens within two years of the spouse's death, when the other conditions are met. There's also a basis adjustment at death that often matters more than the exclusion does. Both are time-sensitive, both are commonly missed, and the difference on a long-held Scottsdale home can be substantial. If you're in this position, that conversation with a CPA is worth having early, and the two-year clock is the reason.

Assuming a second home qualifies. It doesn't, unless it genuinely was your principal residence for two of the last five years. A property in a resort or second-home market that you used a few months a year is a capital asset, and the gain on it's taxable. People mix the two up because both are houses they own.

Buying the next house before anyone has worked out the tax on this one. The old rule that let you roll gain into a replacement home hasn't existed since 1997, and people still believe it does. Buying a more expensive house doesn't defer anything. If you're selling and buying in one move, which is most of the people I work with, the tax question is settled on the sale side and the purchase doesn't change it. That matters for how much of the proceeds you can actually commit to the next place, and it's the kind of thing that belongs in the plan rather than in a surprise.

A couple in a house since 2003, selling and downsizing. They pass the two-of-five test comfortably. They have two decades of improvements, so the real work is documenting basis rather than worrying about the rule. In most cases of this shape the gain lands under $500,000 once basis and selling costs are counted, and there's no federal tax on it. This is the ordinary case, and it's the reason I tell people not to panic before we have run the numbers. If you're here, the useful next step is an accurate read on what the home is worth, because you can't work out a gain against a guess.

A single owner with a very large gain. One filer, $250,000 of exclusion, and a house that has gone up far more than that. Here the exclusion covers part of it and the rest is taxable, so basis documentation stops being tidy bookkeeping and starts being the difference on the return. This is also the case where the timing of the sale across tax years, and how the proceeds are used, are worth planning with an accountant rather than deciding on the fly.

A home being sold out of a trust or after a death. Different rules apply and the exclusion isn't the main event; the basis adjustment usually is. The order of steps matters and some of the options close after a period of time. I handle these regularly and they're their own process, which is why selling a home held in a trust or an estate is a separate conversation on this site rather than a paragraph in this one.

Four steps, and the first two cost nothing.

1. Build the improvement file. Every receipt, invoice, permit and statement you can find for work done on the house since you bought it. Start now, because this takes weeks of remembering rather than an afternoon.
2. Find your original settlement statement. The one from when you bought. It establishes where basis starts and it's the document people most often can't locate.
3. Get a real valuation, not an estimate from a website. A gain calculated against an automated guess isn't a calculation. This is the first thing I do at a listing appointment, and how I arrive at the number is deliberately transparent, because a seller who doesn't believe the number can't make a decision with it.
4. Take all three to your accountant before you sign anything. With a valuation, a basis figure and your filing situation, a CPA can tell you in one conversation whether tax is a factor at all. For most long-time owners it isn't, and knowing that's worth the appointment on its own.

Then the sale itself, which for most of the people I work with is one half of a bigger move. Selling the house you raised a family in and buying the next one aren't two separate projects, and I handle both rather than selling one and handing the other to somebody else. If that's the move you're looking at, how downsizing works when you've been somewhere twenty years covers the part this article doesn't.

If you want to talk it through for your own house, in Scottsdale or anywhere in the Valley, get in touch or call me on (480) 203-6605. Bring what you know about the purchase price and the work you've done, and we will start there.