Homes in the US are selling faster than they have in 20 years, with the average time to find a buyer being just one week!
But buying a home comes with many financial responsibilities. Some you’ll pay upfront, like your down payment and closing costs. Other’s you’ll pay over time, like your mortgage and property tax.
And some you have to pay when you sell the house. This brings us to capital gains tax. If you don’t know about this tax, keep reading as we dig into everything you need to know about capital gains tax on real estate.
What Is Capital Gains Tax?
Capital gains tax is a tax on the profit from an investment that incurred while you owned the asset. You “realize” the profit when you sell the investment and pay capital gains tax.
You only pay the tax after you sell the investment. It doesn’t matter how big the asset is, how long you held the investment, or much much it increased in value.
Additionally, the tax doesn’t apply to “unrealized capital gains.”
Capital gains tax applies to “capital assets.” This includes:
- Stock shares
- Coin collections
- Real estate
To calculate capital gains tax, you deduct the asset’s original cost from the total sale price.
There are two types of capital gains tax. They are long-term and short-term.
You pay long-term capital gains tax on assets you held for longer than a year. The rates are between 0% and 20%, depending on your tax bracket.
On the other hand, you pay short-term capital gains tax on assets you held for one year or less. Short-term capital gains tax follows the same tax rules as ordinary income.
Most taxpayers pay a higher tax rate on short-term capital gains than their ordinary income. This gives Americans an incentive to hold investments for at least a year so that the capital gains tax on the profit is lower.
Of course, this excludes the ultra-wealthy. Capital gains taxes are significantly lower on any capital gains than ordinary income for these Americans. This is just one of the many tax loopholes for the rich.
Tax Planning Considerations
Investors need to be careful when buying and selling assets to minimize the capital gains taxes they pay. This means monitoring how long you hold the investment for (more or less than one year). But it also includes:
- The cost of owning the asset
- Income tax bracket
- Marital status
Your long-term capital gains tax rate may be 0% if you’re below the minimum threshold. But you could also face a 15% or 20% tax rate on capital gains if you fall into a higher income bracket.
For the 2021 tax year, the income threshold to receive a 0% capital gains tax rate is as follows:
- Single up to $40,400
- Married filing jointly up to $80,800
- Married filing separately up to $40,400
- Head of household up to $54,100
For the 2022 tax year, the income threshold to receive a 0% capital gains tax rate is as follows:
- Single up to $41,675
- Married filing jointly up to $83,350
- Married filing separately up to $41,675
- Head of household up to $55,800
For the 2021 tax year, the income threshold to receive a 20% capital gains tax rate is as follows:
- Single over $445,850
- Married filing over $501,600
- Married filing separately over $250,800
- Head of household over $473,750
For the 2022 tax year, the income threshold to receive a 20% capital gains tax rate is as follows:
- Single over $459,750
- Married filing over $517,200
- Married filing separately over $258,600
- Head of household over $488,500
If your income is between these thresholds, your capital gains tax rate is 15%.
Remember the short-term capital gains tax rate is the same as your income tax bracket. Current income tax brackets for are: 10%, 12%, 22%, 24%, 32%, 35% and 37%.
Capital Gains Tax on Real Estate
Real estate usually appreciates over time. This means when you sell a home, you often sell it at a profit rather than a loss. Since you’re making money on the sale, you’re subject to capital gains tax.
However, thanks to some great exceptions, not everyone needs to pay capital gains tax on a property sale.
The Taxpayer Relief Act of 1997 includes provisions to eliminate or lower capital gains tax for homeowners.
You don’t owe any capital gains tax on the first $250,000 of profit from your property sale if you’re single. Married couples (married filing jointly) have a $500,000 exemption.
Further, you can add your cost basis and improvement costs you made to the home to your exemption.
However, the law only allows this exemption once every two years.
For example, if you sold your home of five years in 2021 and applied the exemption to your capital gain taxes, you cannot use it again until 2023.
The 2-in-5-Year Rule
The two-in-five-year rule is another stipulation you must follow to meet the exemption. This rule applies to primary residence based on IRS regulations. It means you must have occupied the residence for at least two of the previous five years.
But, the two years don’t need to be consecutive.
Let’s look at this in practice.
If you bought a home last year, and the value drastically rose this year, you will have to pay capital gains tax if you decide to sell now. But if you bought the home two years ago, meet the primary residence rules, and don’t exceed the profit threshold, you can use the exemption.
For those who own more than one home, the IRS only allows one to be the primary residence. But since the two-in-five-year rule doesn’t require two consecutive years, you can convert a rental property into a primary residence.
For example, if you lived in a home for one year, rented it out for three years, then lived it in again for another year, you may be eligible for the exemption, assuming you meet the other qualifications.
Calculating Capital Gains Tax
Even though there are a lot of numbers involved, calculating your capital gains tax on a home is straightforward. We will assume you are single and meet the primary residence rule for these calculations.
Let’s say you bought a home in 2018 for $250,000. Until now, you lived in the house. If you sell your home for $350,000, your profit is $100,000.
You don’t owe capital gains tax because the profit is less than $250,000.
This time, you sell the home for $600,000. Now your profit is $350,000. You can deduct $250,000, but you need to pay long-term capital gains tax on $100,000. Based on your income bracket, you will know if you owe 0%, 15%, or 20% (see above).
Taxable Home Sale
The capital gains exclusions are great for average homeowners. But there are times when a home sale is fully taxable. We’ve briefly mentioned some of these situations, but here is a complete list. Taxable situations include:
- Home is not the principal residence
- Seller acquired the property through a 1031 exchange within five years (see more below)
- Seller is subject to expatriate taxes
- Seller didn’t owe and use the property as the principal residence for at least two of the previous five years before the sale
- Seller sold another home within two years from the date of the sale and used the capital gains exclusion for that sale
Resident aliens usually have to follow the same tax laws as US citizens.
However, nonresident aliens are subject to different tax rules for selling property. Nonresident aliens who only have US investments don’t have to pay capital gains tax to the US. But they likely need to pay capital gains tax in their home country.
Nonresidents may also face a withholding tax when selling a home.
Additionally, they are subject to a dividend rate of 30% of dividends paid out by US companies. However, some countries have a treaty with the US that lowers this percentage.
Avoiding Capital Gains Tax
As discussed, the easiest way to avoid capital gains tax is to live in the house for at least two years. If you’re flipping a house or know you want to move in under two years, be wary.
You will be subject to short-term capital gains tax if you sell in less than one year. If you own the house for less than two years, you will be subject to long-term capital gain taxes.
For those who own multiple homes, consider changing your primary residence. For example, if you sell your first home and move into your second home, you can sell the second home in two years and take advantage of the capital gains tax exemption.
While some stipulations come with doing this, it’s feasible for most.
However, if the home is only a vacation home, this strategy doesn’t work.
Additionally, adjustments to the cost basis can help reduce your tax bill. You can increase your cost basis by including fees and expenses, home improvements, and additions.
You can also use capital losses from other investments to offset the capital gains from your home. You can even carry over significant losses to following tax years.
State Taxes on Capital Gains
In addition to federal taxes, you’ll most likely need to pay state taxes on capital gains. Most states tax your investment income at the same rate they charge for earned income.
Seven states have no income tax. They are:
- South Dakota
New Hamshire and Tennessee don’t tax earned income but tax investment income. This includes dividends.
Of the states with an income tax, nine tax long-term capital gains less than ordinary income. They are:
- New Mexico
- North Dakota
- South Carolina
Lower rates usually require filling out additional forms. You need to include deductions and credits that reduce the tax rate on capital gains.
Some states give tax breaks to capital gains on in-state investments or specific industries. Contact a tax professional in your city or state for the best guidance to get a better idea of your particular tax responsibilities.
Investment Real Estate
Thus far, we’ve talked about capital gains tax on real estate when selling a principal residence home.
But there are plenty of people who buy investment properties to generate income. These properties have different tax laws.
In short, investment properties do not qualify for capital gains exemptions. But, you can use capital losses to offset capital gains from the sale of investment properties.
And if done correctly, investors can also use the 1031 exchange to avoid capital gains tax.
Internal Revenue Code Section 1031 allows you to defer paying taxes on the sale of a property by reinvesting the funds into a similar property.
Only properties for business and investment purposes can use the 1031 exchange. The investor must identify in writing replacement properties within 45 days from the sale and complete the exchange for a comparable property within 180 days from the sale.
A 1031 exchange is a complex process, so experts advise investors to handle the transaction with a 1031 exchange company.
Property and Real Estate Taxes vs. Capital Gains Tax
Capital gains tax will only ever come into play when you sell a home. But, there are other taxes you need to know when buying property.
Many people use the terms property taxes and real estate taxes interchangeably, but slight differences exist. There are two types of property taxes. Real property taxes and personal property taxes.
The price of an item usually determines the amount of tax you will pay on it. The same is true with real estate. Governments at different levels use real property taxes to pay for public services, schools, etc. Real property taxes are ad valorem taxes.
Conversely, you can calculate your real estate tax by multiplying the property tax rate by the real property’s market value. This value includes the real property (buildings) and the land itself.
Personal property taxes are applied to moveable property. However, since real estate is immovable, it’s not included in personal property tax.
Personal property can include:
Thus, real estate taxes and real property taxes are the same. But, personal property taxes are different.
Understanding Capital Gains Tax
The average American can usually get away without paying capital gains tax on real estate. But, it’s important to remember that homeownership still comes with many other financial responsibilities.
If you’re ever feeling overwhelmed by taxes or need advice on finances, consider speaking with a tax advisor or financial planner.
And don’t forget to check out our other tax guides and financial information on the blog to gain more valuable insights.