Capital gains tax is a tax that applies to the profit you make from selling an asset, such as real estate. Depending on the type, amount, and duration of your gain, you may have to pay taxes on some or all of your profit when you sell your property. However, there are also some exemptions and deductions that can reduce or eliminate your tax liability. In this article, we will explain how capital gains tax on real estate works, who pays it, how much it is, and how to avoid or minimize it.
How Does Capital Gains Tax on Real Estate Work?
When you sell a property for more than what you paid for it, you have a capital gain. The amount of your gain is calculated by subtracting your basis (the original cost plus any improvements) from your sale price (the net amount after deducting any selling expenses). For example, if you bought a house for $200,000, spent $50,000 on renovations, and sold it for $300,000 after paying $10,000 in commissions and fees, your gain would be $40,000 ($300,000 – $10,000 – $200,000 – $50,000).
Your capital gain can be classified as either short-term or long-term, depending on how long you owned the property before selling it. If you owned the property for one year or less, you have a short-term gain. If you owned the property for more than one year, you have a long-term gain. The distinction is important because short-term and long-term gains are taxed at different rates.
Short-term gains are taxed at your ordinary income tax rate, which can range from 10% to 37% depending on your income level and filing status. Long-term gains are taxed at preferential capital gains tax rates, which can be 0%, 15%, or 20% depending on your income level and filing status. Additionally, if your income exceeds certain thresholds ($200,000 for single filers and $250,000 for married filers), you may have to pay an additional 3.8% net investment income tax (NIIT) on your long-term gains.
Who Pays Capital Gains Tax on Real Estate?
Not everyone who sells a property has to pay capital gains tax on real estate. There are some exceptions and exclusions that can exempt you from paying taxes on some or all of your gain. The most common one is the Section 121 exclusion , which allows you to exclude up to $250,000 of your gain ($500,000 if married filing jointly) from your taxable income if you meet the following requirements:
- The property was your primary residence (the place where you lived most of the time) for at least two years out of the five years before the sale.
- You did not use the exclusion for another sale within two years before the current sale.
- You did not acquire the property through a like-kind exchange (a tax-deferred swap of similar properties) within five years before the sale.
If you meet these requirements, you do not have to pay any taxes on your gain up to the exclusion limit. If your gain exceeds the exclusion limit, you only have to pay taxes on the excess amount. For example, if you are single and sold your house for a $300,000 gain after living in it for three years, you can exclude $250,000 of your gain and only pay taxes on the remaining $50,000.
There are also some special rules that can allow you to claim a partial exclusion if you sold your house due to certain circumstances such as divorce, death, job loss, health issues, or natural disasters. You can also defer paying taxes on your gain by reinvesting it in another property through a like-kind exchange but this option is only available for investment or business properties, not personal residences.
How Much Is Capital Gains Tax on Real Estate?
The amount of capital gains tax on real estate that you have to pay depends on several factors such as the type and amount of your gain, your income level and filing status, and any exemptions or deductions that you qualify for. To estimate how much tax you owe on your real estate sale, you can use the following steps:
- Calculate your basis in the property by adding the original cost plus any improvements.
- Calculate your sale price by subtracting any selling expenses from the gross amount.
- Calculate your gain by subtracting your basis from your sale price.
- Determine whether your gain is short-term or long-term by checking how long you owned the property before selling it.
- Apply any exclusions or deductions that you qualify for to reduce your taxable gain.
- Apply the appropriate tax rate to your taxable gain based on your income level and filing status.
For example, suppose you are single and sold a house for a $100,000 gain after owning it for two years. You also have an annual income of $80,000 from other sources. Here is how you can estimate your tax liability:
- Your basis in the property is $200,000 (the original cost plus any improvements).
- Your sale price is $290,000 (the gross amount minus $10,000 in commissions and fees).
- Your gain is $90,000 ($290,000 – $200,000).
- Your gain is long-term because you owned the property for more than one year.
- You can exclude $90,000 of your gain under the Section 121 exclusion because the property was your primary residence for at least two years and you did not use the exclusion for another sale within two years.
- Your taxable gain is $0 ($90,000 – $90,000).
- Your tax rate is 0% because your taxable gain is zero.
- Your tax liability is $0 (0% x $0).
In this case, you do not have to pay any taxes on your real estate sale because you qualify for the full exclusion. However, if your gain or income were higher, you may have to pay some taxes on your sale.
How to Avoid or Minimize Capital Gains Tax on Real Estate?
There are some strategies that can help you avoid or minimize capital gains tax on real estate when you sell your property. Some of them are:
- Plan ahead: If possible, try to time your sale to take advantage of the Section 121 exclusion or the preferential capital gains tax rates. For example, if you are planning to sell your primary residence, make sure you meet the two-year ownership and use requirement before selling. If you are planning to sell an investment property, try to hold it for more than one year to qualify for the lower long-term rates.
- Keep records: Keep track of your basis in the property by saving receipts and documents related to the purchase and improvement of the property. This can help you reduce your taxable gain by increasing your basis. Also keep records of any selling expenses that you incur, such as commissions, fees, closing costs, etc. These can help you reduce your sale price by decreasing your gross amount.
- Make improvements: If you are selling a property that needs renovation or repair, consider making some improvements before selling. This can help you increase the value and appeal of the property, as well as increase your basis and reduce your taxable gain. However, be careful not to over-improve the property beyond what the market can support, as this may not result in a higher sale price or a lower tax liability.
- Use a like-kind exchange: If you are selling an investment or business property, consider using a like-kind exchange to defer paying taxes on your gain. A like-kind exchange allows you to swap your property for another property of similar nature and value without recognizing any gain or loss. This way, you can postpone paying taxes until you sell the new property or until you die (in which case your heirs may get a step-up in basis that eliminates the tax liability). However, be aware that a like-kind exchange involves complex rules and procedures that require professional guidance and assistance.
Conclusion
Capital gains tax on real estate is a tax that applies to the profit you make from selling an asset, such as real estate. Depending on the type, amount, and duration of your gain, you may have to pay taxes on some or all of your profit when you sell your property. However, there are also some exemptions and deductions that can reduce or eliminate your tax liability. The most common one is the Section 121 exclusion , which allows you to exclude up to $250,000 of your gain ($500,000 if married filing jointly) from your taxable income if you meet certain requirements. To estimate how much tax you owe on your real estate sale, you need to calculate your basis, sale price, gain, taxable gain, and tax rate based on various factors. To avoid or minimize capital gains tax on real estate when you sell your property, you need to plan ahead, keep records, make improvements, or use a like-kind exchange .
