Planning to downsize? Three tax considerations for retirees

ARTICLE | April 02, 2024

For many retirees, downsizing their homes isn’t just a choice—it’s a strategic move toward a more manageable and financially secure retirement. Whether it’s to reduce living expenses, adapt to a more accessible living environment, or simply adjust to a life that no longer requires as much space, the decision to downsize can be both practical and liberating. After children leave the nest and the demands of a larger home become less appealing, the lure of a simpler lifestyle grows stronger. 

But there’s another aspect to consider: the capital gains presented by the equity built up in your home. According to Vanguard, home equity makes up roughly half the net worth of homeowners aged 60 and older. For those who purchased their homes decades ago, the numbers are striking. In 2000, the median-priced home was $119,600, while the median home reached nearly $418,000 in December 2023, a 350% increase. This trajectory suggests that many homeowners, especially those with more expensive homes, may have built significant equity through appreciation over the years. 

This realization prompts important questions: how might your home's appreciation impact your taxes, and what strategies can you employ to minimize the tax burden? 

1 - Consider your tax Bracket

Federal capital gains tax is levied on the profit made from selling assets, such as real estate, that have been owned for more than a year. While capital gains are taxed at rates more favorable than ordinary income taxes, they can still be substantial depending on your filing status, annual income, and the amount your home has appreciated in value over time. 

Long-term capital gains tax rates are tiered at 0, 15, and 20% based on your taxable income. In 2024, the capital gains rates are: 

If you are facing a potential capital gain (beyond any exclusion) if you sell your home, you should consider your current and future income levels when planning a sale. If you’re still earning a significant income, waiting until you retire could place you in a lower tax bracket, potentially reducing the amount owed in capital gains tax. Of course, this is just one factor to consider when to sell your home. 

2 - Plan ahead to maximize the capital gains tax exclusion

There is a capital gains tax exclusion on the sale of a primary residence if you qualify. Single filers can exclude up to $250,000 of the capital gains. Married couples filing jointly can exclude up to $500,000. To be eligible for this exemption, you must have used the property as your primary residence for at least two of the five years preceding the sale. Additionally, this exclusion cannot be claimed more than once every two years.

If the profit from selling your home exceeds the applicable exclusion limit, the surplus will be taxed as a capital gain. Understanding this threshold is crucial in planning your sale to minimize potential tax liabilities.

The generous exclusion for married couples presents a compelling case for considering downsizing while both spouses are still together. Life's unpredictable nature means that circumstances can change, often unexpectedly. If a spouse becomes widowed, the surviving spouse's eligibility for the exclusion reduces to the single filer amount, which is half of what couples can claim. This change can significantly impact the tax benefits of selling your home.

Addressing such a sensitive topic requires thoughtful consideration. It’s pragmatic to acknowledge that planning for the future involves preparing for various scenarios, including those we may not wish to contemplate. Downsizing while still married not only maximizes your financial benefits under current tax laws but also ensures a smoother transition to the next chapter of life, should circumstances change.

3 - Keep track of your capital improvements

If you don’t qualify for the exclusion or only a portion of your gain is exempt, there may still be ways to reduce your taxes. 

First, you’ll need to calculate the cost basis of your home accurately. This figure isn’t just the amount you originally paid for your property; it also includes the total of all capital improvements you’ve made over the years. To determine your cost basis, start with the original purchase price of your home, then add the cost of any significant improvements - such as remodeling a kitchen, adding a bedroom, or upgrading your heating system. Essentially, any improvements that add to the value of your home can increase its cost basis. 

Suppose you bought your house for $200,000 and later invested $50,000 in a major renovation. If you haven't already factored these improvements into your cost basis, doing so now could significantly reduce your taxable gain. 

To ensure that you can take full advantage of your adjusted cost basis, maintain detailed records of all home improvements and relevant expenses. Receipts, contracts, and before-and-after photos can serve as valuable documentation if the IRS requires proof of the improvements made. This documentation is essential not only for verifying your costs but also for simplifying the process of calculating your home’s adjusted cost basis.

Professional guidance

As you consider the possibility of downsizing, it’s crucial to understand the tax implications. A tax professional can help you understand aspects of the financial landscape you might not have considered and offer strategies to optimize your position when the time comes to downsize. 

This article highlights key considerations that are often overlooked in the planning stages of downsizing. By keeping these factors in mind, you can better prepare for the financial implications of such a significant life change. For a comprehensive evaluation and advice suited to your personal situation and goals, we encourage you to contact one of our expert advisers.