Becoming a homeowner is a huge accomplishment, and a solid investment. When you purchase a home, your first thought likely isn’t about the price you’ll get for it when you sell someday. Instead, you’re probably thinking of improvements you want to make, or how to start decorating. But, as home values increase it’s important to understand that your home is considered a capital asset. Thus, it’s subject to capital gains tax. In some cases, if you’re not careful, you may end up selling your home for less than you bought it for after paying capital gains tax on real estate.
We’re here to help you understand what capital gains tax on real estate is, and how to keep the amount at a minimum.
What is Capital Gains Tax on Real Estate?
You may have heard the term capital gains tax in relation to investments, but do you know what it means in real estate?
A home, whether your primary residence or an investment property is considered a capital asset. When you sell a capital asset for more than you bought it for, you pay capital gains tax on the gain from the sale. Any gains you made from the sale of a home must be reported to the IRS. But, the good news is the IRS provides an exception to qualifying homeowners to help them avoid capital gains tax on real estate.
To be considered exempt, the home must be a primary residence. The IRS has specific rules to determine what is considered a primary residence.
How Does It Work?
The IRS and most states assess capital gains taxes on real estate on the difference between what you pay for the home and what you sell it for. When a homeowner sells their property for more than they paid for it, this is called a capital gain. This is either a short term, or long term gain and taxed accordingly.
Short Term Capital Gains Tax on Real Estate
Short-term capital gains tax on real estate occurs when you sell a property you held for 12 months or less. This gain is taxed as ordinary income. This means the homeowner pays the same tax rate on the short-term gains that they would on ordinary income from their employer. For 2021 there were 7 tax brackets, ranging from 10% to 37%.
Homeowners who purchase a primary residence, but sell it less than 12 months later regardless of the circumstances will have to pay capital gains tax on real estate. Investors are also subject to short term gains tax. For example, investors who focus on flipping homes typically try to turn a property over as quickly as possible. Thus, typically profits on flipped properties are taxed as short-term gains.
Long Term Capital Gains Tax on Real Estate
Homeowners who hold a property for over one year are subject to long-term capital gains tax on real estate. These gains are taxed at a lower rate than short-term gains depending on your income and filing state.
Primary Residence vs Investment Property
Capital gains on real estate applies to all homeowners who profit from the sale of a property, whether you own a primary residence, or multiple investment properties. Aside from flipping homes, investors typically hold other investment properties for over a year to capitalize on lower long term capital gains rates.
Whether you own a primary residence or investment property, your capital gains on real estate tax rate is determined by your income. Remember, you are only taxed if you make a profit, and do not meet the IRS requirements for exemption from capital gains tax on real estate. Your tax is charged at your income tax rate as follows:
$0 to $40,000 income – 0% tax rate
$40,001 to $441,450 – 15%
$441,451 or more – 20%
When is a Home Fully Taxable?
Not everyone can take advantage of the capital gains exclusions. Gains from a home sale are fully taxable when:
- The home is not the seller’s primary residence
- The property was acquired through a 1031 exchange within the last five years
- The property was not used as the owner’s principal residence for at least two of the last five years prior to the sale
- The seller sold another home within the previous two years from the date of the sale and used the capital gains exclusion for that sale.
- The seller is subject to expatriate taxes
How to Calculate Capital Gains Tax on Real Estate
If the property in question is your primary residence, and you’ve lived there for 2 years, the IRS typically allows your to exclude the following:
- $250,000 of capital gains on real estate for single individuals
- $500,000 of capital gains on real estate married couples or those filing jointly
For example, you and your spouse purchased a house 10 years ago for $200,000. Today, it sold for $700,000. Since you are married and filing jointly, you’re able to exclude $500,000, or in this case the ensure capital gain on the property.
Homeowners who don’t quality for exclusion from Capital Gains
If you’ve determined that you are not eligible for the exemptions provided by the IRS for capital gains tax on real estate, then it’s time to calculate what you can expect to owe.
Start by taking into account your cost basis. This is the amount you paid for the property, and any improvements done. The amount you pay to purchase the home can include closing and appraisal costs and any legal fees. It’s also a great idea to keep track of the improvements you make to a home, and keep all receipts.
For example, an investor purchased a home for $200,000. They also paid $6,000 in closing costs, and spent $25,000 on improvements. Ultimately, their cost basis is the total of these amounts, $231,000. The investor can subtract this total cost basis from the price they eventually sell the property for. In addition, the investor can also subtract the sale costs, such as commission to get the net proceeds.
Ultimately, to calculate the capital gain on a property when selling it, subtract the cost basis from the net proceeds. If the net proceeds are a positive number, you have a gain. When they are a negative number, you have a loss. If you have a gain, that amount is what you pay capital gains tax on in real estate. Take your capital gains tax rate multiplied by the capital gain to calculate what you owe. For example, if you have a capital gain of $50,000 and fall within the 15% long-term capital gains rate, you would owe $7,500.
How to Avoid Capital Gains Tax of Real Estate
Homeowners can sell their primary residence and be excluded from paying capital gains tax on the first $250,000 of gain. This is if you’re filing your taxes with a single status of single. Alternately, if you file jointly, you’re exempt from the first $500,000 of capital gain. It’s important to note, you’re only eligible for this exemption once every two years. You must also prove that your home is your primary residence. In order to do so you need to show:
- You owned the home for a minimum of two years.
- You lived in the property as a primary residence for at least two years.
There are a few ways to work within these rules to minimize your tax burden. For example, you don’t have to show that you lived in the home the entire time you owned it. With that, you don’t have to live in the home for two years consecutively. You can choose to live in the home for one year. Then, rent the property if you choose to move, before living in the property for another year prior to selling.
You can defer paying capital gains tax on real estate by doing a like-kind exchange. A provision in the US tax code, section 1031 allows you to sell an investment property and buy a like kind property, ultimately deferring paying taxes. This comes with a strict time limit. You’re required to purchase a new property within a specific number of days after selling the original property.
Offset your capital gains with capital losses
You can lower your tax liability when you sell an investment property by pairing the gain from a sale with the losses from other investments. For example, did you know cars are considered capital assets?
The Bottom Line
Capital gains tax on real estate can really put a damper on selling your property for a profit. Luckily, there are ways to defer these taxes, or at the very least, lower them. A qualified real estate agent can help you build your team of experts as you invest in real estate, or simply prepare to sell your primary residence. Speak with a Trelora agent today to learn how you can save thousands of dollars when you buy or sell a home. Our agents close hundreds of deals each year. So, you can feel confident completing a 1031 exchange with an expert on your side.
Brock Embree joined Trelora in 2017. In 2018, he was part of the founding team that opened Trelora’s Seattle, Washington office, their first expansion beyond Colorado. In 2020, he repeated the process, opening yet another new market for Trelora in Arizona. His team has closed over 200 deals in Phoenix and has expanded to serve Tucson in addition to their growing customer base in Phoenix.