Capital Gains Tax On Real Estate: A Complete Guide
Even though the housing market has experienced a slowdown in the past year, prices in numerous regions remain high following the substantial increase from 2020 to 2022.
The accrued appreciation has positively impacted the net worth of property owners. However, it also implies that an increasing number of owners should be prepared for a potential capital gains tax obligation when they decide to sell.
So what is a capital gains tax on real estate?
We’re here to help you understand what it is and how it works, in case you’re thinking about selling a home now or in the future.
What Is The Capital Gains Tax On Real Estate?
When you sell an asset that increases in value, you may have to pay money on the profit from that investment – this is the capital gains tax. In other words, it’s what you pay for the appreciation from your investment. The amount you pay in capital gains taxes depends on your income, tax filing status and how long you owned the asset.
Any asset that appreciates is subject to capital gains taxes – including real estate. In this article, we’ll solely focus on capital gains taxes that apply to real estate and the special rules that provide an exemption on the sale of a primary residence.
If you sold your home after living in it for a year or less, you may have to pay the short-term capital gains tax, which means your profit is categorized as ordinary income. If you were in the home for over a year, your long-term capital gains tax will instead be calculated based on your income tax bracket.
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When Do Homeowners Have To Pay The Capital Gains Tax?
Selling a house after it’s increased in value usually means you’ll have to pay the capital gains tax. However, there are some exemptions.
Here are a few scenarios where a homeowner would be expected to pay the capital gains tax:
- The homeowner makes more than $250,000 on the sale of their house as a single individual, or $500,000 on the sale of the home with their spouse. In general, a homeowner doesn’t have to pay capital gains taxes if they make less than those amounts.
- The home being sold is not a primary residence. If you don’t live in the home for more than half of the year, it’s not considered your primary residence.
- The seller hasn’t owned and/or used the home for at least 2 of the last 5 years.
How Does The Capital Gains Tax Work For The Sale Of A Home?
If you own a home, you’ll want to know the rules of capital gains taxes so you’re familiar with what will happen if you decide to sell your home.
Capital gains and losses are handled according to the holding period, or how long you’ve held them. You pay short-term capital gains on profits you make from selling assets you’ve held for a year or less. On the other hand, you’ll pay long-term capital gains from assets you’ve held for longer than a year.
You’ll face different rules and tax rates depending on whether you make short- or long-term capital gains. You usually pay less in taxes on long-term capital gains compared to short-term capital gains.
Let’s use this example in a real estate context. Say you own a property for 6 months. If you sell it for a profit after that time, it’s considered a short-term gain. You’ll get taxed at your marginal tax rate (tax bracket). However, after a year, think of any profit as a long-term capital gain.
Short-Term Capital Gains Tax Rates
Short-term capital gains generally do not qualify for special tax rates. They are typically subject to taxes at the standard rates applicable to ordinary income. This tax rate is determined based on your income and filing status. Some things to consider regarding short-term capital gains include:
- The holding period for these gains starts counting from the day following the asset acquisition and extends until the day of sale.
- Ordinary tax rates, ranging from 10% to 37%, apply to short-term capital gains, with the specific rate determined by your income level and filing status.
2024 Short-Term Capital Gains Tax Rates
Filer Status | 10% Tax Rate | 12% Tax Rate | 22% Tax Rate | 24% Tax Rate | 32% Tax Rate |
|---|---|---|---|---|---|
Single | Up to $11,000 | $11,001 to $44,725 | $44,726 to $95,375 | $95,376 to $182,100 | $182,101 to $231,250 |
Married (filing jointly) | Up to $22,000 | $22,001 to $89,450 | $89,451 to $190,750 | $190,751 to $364,200 | $364,201 to $462,500 |
Married (filing separately) | Up to $11,000 | $11,001 to $44,725 | $44,726 to $95,375 | $95,376 to $182,100 | $182,101 to $231,250 |
Head of household | Up to $15,700 | $15,701 to $59,850 | $59,851 to $95,350 | $95,351 to $182,100 | $182,101 to $231,250 |
Trusts and Estates | $0 – $3,100 | Not Applicable | Not Applicable | $3,100 – $11,150 | Not Applicable |
35% Tax Rate | 37% Tax Rate |
|---|---|
$231,256 to $578,125 | Over $578,125 |
$231,251 to $578,100 | Over $693,750 |
$462,501 to $693,750 | Over $346,875 |
$231,256 to $578,125 | Over $578,125 |
$11,150 – $15,200 | Over $15,200 |
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Long-Term Capital Gains Tax Rates
By owning assets for more than a year, you can usually take advantage of a lower tax rate on the resulting profits. Individuals in lower tax brackets may even be exempt from paying any capital gains tax, while those with higher incomes could potentially enjoy a tax saving of up to 17% compared to the ordinary income rate, according to the Internal Revenue Service (IRS).
2024 Long-Term Capital Gains Tax Rates
Filer Status | 0% Tax Rate | 15% Tax Rate | 20% Tax Rate |
|---|---|---|---|
Single | Up to $47,025 | $47,026 to $518,900 | Over $518,900 |
Married (filing jointly) | Up to $94,050 | $94,051 to $583,750 | Over $583,750 |
Married (filing separately) | Up to $47,025 | $47,025 to $291,850 | Over $291,850 |
Head of household | Up to $63,000 | $63,001 to $551,350] | Over $551,350 |
Trusts and Estates | $0 – $3,150 | $3,150 – $15,450 | Over $15,450 |
How To Avoid Or Reduce Your Capital Gains Tax For Real Estate
There are ways a homeowner or investor can reduce their capital gains tax when selling real estate. To help reduce what you owe:
1. Satisfy The 2-In-5-Year Requirement
If you lived in the home for at least 2 years out of the last 5 years and used it as your primary residence, you meet the residence requirement. The 24 months can be spread out over the 5-year period and don’t have to be continuous – the key is reaching a total of 24 months (730 days) of residence within that timeframe.
2. Qualify For An Exemption
Remember, there are several specific situations that may qualify for an exemption, such as:
- The home was a primary residence and the homeowner made less than $250,000 in profit and is doing their taxes as a single filer.
- The home was a primary residence and the homeowner made less than $500,000 in profit and is married, filing jointly.
- If the home was sold because of work or an unforeseen circumstance, the IRS might allow an exemption.
- The homeowner is a member of the U.S. Military and had their service extended.
3. Adjust Your Cost Basis
The cost basis in real estate serves as the original value that a buyer pays for a property. Here’s the simple math problem you can use to figure out your cost basis:
The Purchase Price (including any closing costs) + Capital Improvements = Cost Basis
You may need to pay capital gains tax on any profit you generate above and beyond what you initially paid for your property, and the cost basis determines what you’ll have to pay in tax when you sell your property.
4. Do A 1031 Exchange
A 1031 exchange allows you to sell an investment or business property and buy another without paying capital gains taxes. The exchange must meet IRS rules and be a like-kind property, which means a property of the same nature. In other words, you trade one real estate investment for another.
However, it’s important to note that you defer capital gains taxes – you don’t get out of them completely. If there are capital gains when you sell your final real estate investment, and you’re not doing another 1031 exchange, you will have to pay capital gains tax.
5. Convert The Home Into A Primary Residence
A seller can convert a home into a primary residence before selling the property to help avoid the capital gains tax. For instance, if you had a vacation home – where you only spent summers – you could sell your primary residence and move into your vacation home. A scenario like this may qualify you for the capital gains exemption.
Note that if you sell a rental property, you’ll have to pay a capital gains tax on any profit you earn from the sale.
The Bottom Line
Remember, the capital gains tax is what you pay for the appreciation from your investment. Selling a home can increase your revenue, but you want to make sure you understand how much you’ll be paying for the capital gains tax. However, there are ways a seller can reduce their tax bill when selling real estate.
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