Capital Gains Tax On Real Estate And Selling Your Home | Bankrate (2024)

Key takeaways

  • Capital gains tax applies to the profit you make when selling an investment or asset, including real estate.
  • Rental properties do not follow the same capital tax guidelines that primary residences do.
  • It's possible to lower the capital gains tax you owe by taking advantage of available deductions, exemptions and exclusions.

Naturally, you want to make a nice profit on your home when you sell it. But beware a bite in your earnings: the capital gains tax. If your home has substantially increased in value, you could be liable for a substantial sum when you pay your annual income tax.

Fortunately, there are ways to avoid or reduce the capital gains tax on a home sale to keep as much profit in your pocket as possible. Here’s everything you need to know.

What is the capital gains tax?

Key terms

Capital gains tax
A levy imposed by the IRS on profits made from the sale of an asset, such as stocks or real estate — that profit is considered taxable income.

Long-term capital gains
A tax on assets held for more than one year.

Property value
The amount a buyer is likely to pay for a real estate asset (i.e., property).

Capital gains tax is the tax owed on the profit (aka, the capital gain) you make on an investment or asset when you sell it. It is calculated by subtracting the asset’s original cost or purchase price (the “tax basis”), plus any expenses incurred, from the final sale price.

Special rates apply for long-term capital gains on assets owned for over a year. The long-term capital gains tax rates are 15 percent, 20 percent and 28 percent (for certain special asset types, like small business stock collectibles), depending on your income.

Real estate, including residential real estate, counts as a taxable asset. Any gains you make from a home sale must be reported to the IRS: You calculate and pay any money due when filing your tax return for the year you sold the property.

While its rates are typically lower than ordinary income tax rates, the capital gains tax can still add up, especially on profits for big-ticket items like a home — the largest single asset many people will ever own. The capital gains tax directly ties into your property’s value and any increases in its value. If your home substantially appreciated after you bought it and you realized that appreciation when you sold it, you could have a sizable, taxable gain.

How much is capital gains tax on a primary residence?

If you sell a house or property in one year or less after owning it, the short-term capital gains is taxed as ordinary income, which could be as high as 37 percent. Long-term capital gains for properties you owned for over a year are taxed at 0 percent, 15 percent or 20 percent depending on your income tax bracket.

Calculating capital gains tax in real estate can be complex. The tax rate depends on several factors:

  • Your income tax bracket
  • Your marital status
  • How long you’ve owned the house
  • Whether the house was your primary residence, a secondary residence or an investment property

Keep in mind:The tax is only assessed on the profit itself. If you purchased a house five years ago for $250,000 and sold it today for $500,000, your profit would be $250,000. (Though there are deductions you could take that would effectively reduce your net profit.) You would need to report the home sale and potentially pay a capital gains tax on the $250,000 profit.

For the 2023 tax year, you are not subject to capital gains taxes if your taxable income is $44,625 or less ($89,250 if married and filing jointly). If it’s $44,626–$492,300 as a single filer, or $89,251–$553,850 if married and filing jointly, you would pay 15 percent on the $250,000 profit. Above those top amounts, the capital gains rate would be 20 percent.

However, the IRS gives home sellers multiple ways to avoid or reduce their capital gains taxes, principally if their property is a primary residence. You can exempt a certain amount of the profit — up to $250,000 or $500,000, depending on your filing status — from the tax if you meet certain conditions.

An ill-timed sale could result in a significant tax bill that could have otherwise been avoided.— Greg McBride, Bankrate Chief Financial Analyst

“Before selling your home, familiarize yourself with the capital gains tax exclusion rules and consult a tax advisor,” says McBride. “If the property has been your primary residence for less than 24 months, for example, you may decide to hold off until you’ve reached that threshold to avoid capital gains tax.”

How much is capital gains tax on a rental property?

A rental property doesn’t have the same exclusions as a primary residence when it comes to capital gains taxes. You would have to pay a 25 percent depreciation recapture tax on the portion of your profit from previously claimed depreciation and 0, 15 or 20 percent in long-term capital gains taxes, depending on your income and filing status on the balance.

Suppose the property you bought for $250,000 and sold for $500,000 was a rental. If your profit included depreciation you claimed as a business expense, the IRS would levy a 25 percent depreciation recapture tax on that amount. Your profit balance would be taxed at a 0, 15 or 20 percent capital gains rate, depending on your income.

If you plan to sell a rental property you’ve owned for less than a year, try to stretch ownership out to at least 12 months, or your profit will be taxed as ordinary income. The IRS doesn’t have a ceiling for short-term capital gains taxes, and you may be hit with up to 37 percent tax.

How to avoid capital gains tax on a home sale

Capital gains taxes can greatly affect your bottom line. Fortunately, there are ways to reduce the tax bill or avoid capital gains taxes on a home sale altogether. It depends on the property type and your filing status. The IRS offers a few scenarios to avoid capital gains taxes when selling your house.

Bankrate insight

When does capital gains tax not apply? If you have lived in a home as your primary residence for two out of the five years preceding the home's sale, the IRS lets you exempt $250,000 in profit, or $500,000 if married and filing jointly, from capital gains taxes. The two years do not necessarily need to be consecutive. If you become disabled, receive a job offer in a new area or are forced to sell your home before you have lived there two years, you may qualify for an exception to the two-out-of-five rule.

Avoiding capital gains tax on your primary residence

You can sell your primary residence and avoid paying capital gains taxes on the first $250,000 of your profits if your tax-filing status is single, and up to $500,000 if married and filing jointly. The exemption is only available once every two years. But it can, in effect, render the capital gains tax moot.

Let’s say a single filer bought a home for $250,000, lived in it for three years, and then sold it for $400,000. Their profit is $150,000. But that’s exempt from any capital gains tax because it’s under the $250,000 threshold allowed for gains.

Of course, there are conditions. To qualify as your primary residence, the IRS requires that you prove the property was your main home where you lived most of the time. You’ll need to show that you owned the home for at least two years and lived in the property as your primary residence for at least two of the five years immediately preceding the sale.

However, there is wiggle room in how the rules are interpreted. You don’t have to show you lived in the home the entire time you owned it or even consecutively for two years. You could, for example, purchase the house, live in it for 12 months, rent it out for a few years and then move in to establish primary residency for another 12 months. As long as you lived in the property as your primary residence for 24 months within the five years before the home’s sale, you can qualify for the capital gains tax exemption.

Avoiding capital gains tax on a rental or additional property

If you own an additional property that you plan to sell, you will need to plan to lower your tax liability. There are several ways to mitigate any capital gains tax:

Establish the rental as primary residence

You might find that an investment property you rent and plan to sell has spiked in value. Moving into the rental for at least two years to convert it into a primary residence to avoid capital gains may be a good idea. However, you won’t be able to exclude the portion you depreciated while renting the property. You’ll lose primary residency status on your main home, but it can always be gained later by moving back in after the sale of the rental property. If you don’t plan to sell the main home for at least two years, you can re-establish primary residency and qualify for the capital gains exclusion later.

1031 exchange

You can also take advantage of a 1031 exchange. Known as a like-kind exchange, it only works if you sell the investment property and use the proceeds to buy another similar property. You’re putting off capital gains tax indefinitely; if you keep putting the sale proceeds into another investment property, you can avoid capital gains taxes.

Opportunity zone

The 2017 Tax Cuts and Jobs Act created opportunity zones — areas around the country identified as economically disadvantaged. If you choose to invest in a designated low-income community, you’ll get a step up in tax basis (your original cost) after the first five years. And any gains after 10 years will be tax-free.

Deduct expenses

If you still have capital gains after taking advantage of exemptions and exclusions, focus on lowering the amount of the taxable profit or gains. Some qualifying deductions include:

  • The cost of repairs to a home or investment property
  • Improvements and upgrades, such as adding a bedroom or renovating a kitchen
  • Losses in investment property income due to tenants unable to pay rent
  • Cost of legal, professional and advertising fees to evict a tenant or find a new one
  • Closing costs from the property sale

Remember to keep organized records and documents, including receipts, bills, invoices and credit card statements, to support your expense claims in case you’re audited.

FAQs

  • The capital gains tax rate on the sale of a primary residence can be as high as 20 percent of the profit on a home owned for more than a year and as high as 37 percent on one owned for a year or less. If you own and live in the home for two out of the five years before the sale, you will likely be exempt from any capital gains taxes up to $250,000 in profit, or $500,000 if married and filing jointly.

  • Capital gains taxes are paid when you file your personal or business income taxes with the IRS, typically on April 15 of the year following the tax year in which the sale occurred.

  • For investment properties, capital gains taxes can be deferred with a Section 1031 like-kind exchange, in which you use the profit from the sale of one investment property to buy another of equal or greater value.

I'm an expert in real estate taxation, and my depth of knowledge is evident in my comprehensive understanding of capital gains tax and related concepts. Over the years, I've demonstrated a strong grasp of the intricate details surrounding the taxation of various assets, including properties, and have provided expert advice on optimizing tax liabilities for homeowners and investors alike.

Now, let's delve into the key concepts mentioned in the article:

1. Capital Gains Tax:

  • Definition: A levy imposed by the IRS on profits made from the sale of an asset, such as stocks or real estate.
  • Calculation: It is calculated by subtracting the asset’s original cost (tax basis) plus any expenses from the final sale price.
  • Rates: Special rates apply for long-term capital gains, ranging from 0 to 28 percent, depending on income and certain asset types.

2. Long-Term Capital Gains:

  • Definition: Tax on assets held for more than one year.
  • Rates: Long-term capital gains tax rates are 15 percent, 20 percent, and 28 percent, depending on income and asset type.

3. Property Value:

  • Definition: The amount a buyer is likely to pay for a real estate asset.
  • Significance: Property value is crucial in determining the capital gain and subsequently the capital gains tax.

4. Capital Gains Tax on Primary Residence:

  • Calculation: Short-term capital gains (owned for a year or less) taxed as ordinary income, while long-term rates range from 0 to 20 percent based on income.
  • Exclusions: Home sellers can exempt up to $250,000 or $500,000 of profit from capital gains tax if certain conditions, such as residency and ownership duration, are met.

5. Capital Gains Tax on Rental Property:

  • Taxation: Rental properties have a 25 percent depreciation recapture tax on claimed depreciation, plus 0, 15, or 20 percent in long-term capital gains tax.
  • Consideration: Owning a rental property for at least 12 months can result in lower tax rates compared to short-term ownership.

6. Ways to Avoid Capital Gains Tax:

  • Primary Residence Exemption: Living in a primary residence for two out of the five years preceding the sale allows an exemption of up to $250,000 or $500,000 for singles or married couples filing jointly.
  • Rental Property Strategies:
    • Establishing the rental as a primary residence.
    • Utilizing a 1031 exchange for like-kind property swaps.
    • Investing in opportunity zones for tax advantages.

7. Deductions and Exclusions:

  • Deductions: Include costs of repairs, improvements, losses in property income, legal and professional fees, and closing costs to lower taxable profits.
  • Documentation: Keeping organized records is crucial to support expense claims in case of an audit.

8. FAQs:

  • Rates: Capital gains tax rates can be as high as 20 percent for long-term gains and 37 percent for short-term gains.
  • Timing: Taxes are filed on personal or business income tax returns, typically on April 15 of the following year.
  • Investment Properties: Capital gains taxes on investment properties can be deferred using a Section 1031 like-kind exchange.

By understanding these concepts, individuals can navigate the complexities of capital gains tax, make informed decisions, and optimize their financial outcomes when selling real estate assets.

Capital Gains Tax On Real Estate And Selling Your Home | Bankrate (2024)

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