You may be at the stage in life where your kids are out of the house—or perhaps you’re just looking for a change—and want to downsize your home. There’s no question that downsizing can have many financial advantages. A smaller house can mean less upkeep, lower monthly expenses— and maybe even potential cash from a sale.

But before making a decision, it’s important to assess how taxes could come to play a part. Will selling your home be worth it if it comes with a big tax bill?

Under current law, if you sell your principal residence for a profit, up to $250,000 of that capital gain can be excluded from tax.¹ Married couples filing a joint return can exclude up to $500,000. This means that many people won’t have to pay capital gains tax at all. However, that may not always be the case. Those who have owned their homes for decades or live in areas that have experienced considerable appreciation, could face a significant bill.

First, the basics

In order to claim the maximum exclusion, you will need to pass what the IRS calls the ownership and use tests. This means:

1. You must have owned the house for at least two years.
2. And you must have lived in the house as your principal residence for two out of the last five years, ending on the date of the sale.

There are exceptions to these rules—for example, moving before owning the home for two years due to a job change—or experiencing what the IRS designates an “unforeseen circumstance,” such as a divorce or natural disaster. If you fall under any of these cases, the IRS will allow you to prorate the exclusion. One thing to note, if you go through a divorce after having lived in the home for just one year, you would be entitled to only 50% of the exclusion.

Additionally, the two years of residency don’t have to be consecutive so long as you’ve lived in your home for a total of 24 months out of the five years prior to the sale. You’re also able to claim this exclusion on multiple sales, but you can only claim this exclusion once every two years.

Calculate your cost basis

To determine capital gains on the sale of your home, subtract your cost basis from the selling price. But what exactly is your cost basis? It’s not just the purchase price.

Your cost basis can include certain settlement fees, closing costs and commissions associated with both the purchase and the sale—excluding escrow amounts related to taxes and insurance, etc.²  Add to this the cost of significant capital improvements (but not repairs) you made over time for renovations, additions, roofing, landscaping and other upgrades. All of these improvements will increase your cost basis, and therefore lower your potential tax liability. Hopefully, you’ve kept good records because this can add up.

On the other side of the equation, there are a few things that can reduce your cost basis, which will increase your profit, and potentially your taxes. For example, if you received tax credits for energy-related improvements, you will have to subtract those amounts from your cost basis. Also, if you had a home office and claimed depreciation over time, you may have to “recapture” that depreciation and pay tax on that amount.

Capital improvement or repair?

Tax rules let you add the cost of a capital improvement to your cost basis, but not the cost of a repair. The difference? A capital improvement increases the value of your property. A repair simply restores your property to its original condition.

A new deck is a capital improvement. Fixing your plumbing is a repair. Sometimes, though, the distinction is less clear. For example, if you replace your entire roof, that’s a capital improvement. But if you simply replace a few shingles, that’s a repair.

A sample tax bill

Jon and Jane bought their home in 1988 for $250,000. Now in their mid-60s, they’ve decided to downsize. They sell their home for $875,000.

Over the years, Jon and Jane did a lot of remodeling and made many home improvements. Because Jane has a home office, they’ve claimed depreciation on their income tax return, which now has to be subtracted from the cost basis. They are in the 25% tax bracket and pay a 15% long-term capital gains tax rate. Here are the numbers.

What did they spend?

Purchase price of home 

$250,000

Allowable settlement fees and closing costs:	+ $12,500
Kitchen and bath remodels:	+ $50,000
New roof:	+ $20,000
New landscaping:	+ $15,000
Less: Depreciation from home office	= $347,500   - ($50,000)
COST BASIS	= $297,500

What did they sell it for?

Sales price$875,000

Commission and sales fees	- ($55,000)
GROSS PROFIT	= $820,000

How much did they make?

Gross profit$820,000

Cost basis	- ($297,500)
CAPITAL GAINS	= $522,500

How much do they owe in capital gain taxes?

Capital gains$522,500

Capital gains exclusion (married filling jointly):	- ($500,000)
Taxable gain Capital gains tax rate (15%)	= $22,500 x       0.15
CAPITAL GAINS TAX DUE	= $3,375

Note: Jon and Jane must also “recapture” the $50,000 of home office depreciation deductions on their tax return as a “unrecaptured section 1250 gain.” In this example it will be taxed at the maximum rate of 25% ($12,500 in tax). They would have to do this even if their capital gain was less than their $500,000 exclusion.

Looking ahead: Rent or buy?

Your next big decision will be figuring out where to live. Downsizing may mean buying a smaller house or moving to a less expensive area. Alternatively, you could decide that it would make more sense to rent.

On the plus side, renting releases you from worry about things like property taxes and upkeep—potentially giving you more freedom both economically and emotionally. If you don’t deposit money into another house, it could also give you a nice retirement nest egg. On the minus side, if you rent you won't be building equity and you’ll be subject to the whims of a landlord.

There's no right or wrong answer. A lot will depend on where you live and whether you plan to stay in your next home long term. In either case, if you make a considerable profit on the sale of your home, talk to Schwab about the best way to invest this money in light of your overall financial situation.