Long-term capital gains (gains on property held for more than a year) are generally taxed at either 0%, 15%, or 20% depending on certain limits. If your gains cross the threshold for 15%, the overage will be taxed at 20%.
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Guide to understanding capital gains on real estate
Capital gains on real estate refer to the profit made when selling a property. Understanding its tax implications and exceptions is crucial to a sound financial strategy.
Key takeaways:
- When property is sold at a profit, the sale triggers capital gains tax.
- Special exemptions may allow you to minimize or even avoid capital gains tax on real estate transactions.
What is capital gains tax?
Capital gains tax is the tax you pay on the profit from selling an asset. In real estate, this tax applies whenever you sell a home, rental property, or land for more than you paid for it. It plays a major role in determining how much of the profit you can keep after a sale.
Related: What is capital gains tax?
Capital gains tax in real estate sales
When you sell real estate, whether it’s your primary home or an investment property, the IRS treats your profit as a capital gain. How much you owe depends on several factors, including how long you’ve owned the property, your income level, and any exclusions that may apply.
Capital gains on primary residence
If the property you’re selling is your primary residence, you may be able to take advantage of tax exemptions for capital gains on a home sale:
If you’ve lived in a residence for at least two of the past five years, the IRS allows you to exclude up to $250,000 in gain.
Married couples filing jointly can exclude up to $500,000.
Surviving spouses may also qualify for the $500,000 exclusion within two years of their spouse’s death.
Capital gains on inherited property
When a property is transferred after someone passes away, the person who receives the property receives a stepped-up cost basis. This means that they take the property at its fair market value at the time of the original owner’s death and are not responsible for any unrealized gains that were made before they took ownership. For example:
The original owner bought a property for $400,000, and it was worth $450,000 at their death.
The person who inherits it will receive it at a cost basis of $450,000 and not owe capital gains at that time.
If they then sell the property for $600,000, their gain will be $150,000 ($600,000 - $450,000) rather than the $200,000 ($600,000 - $400,000) it would have been had they not received the stepped-up cost basis.
This exemption can lead to significant savings on inherited property. It’s also advisable to have a sound estate plan in place to help ensure the smooth transition of property.
Capital gains on investment property
Investing in real estate can be a great way to increase your wealth. When selling, capital gains on investment property can be deferred in certain circumstances. For example, if you sell a rental property for $720,000 and purchase another similar rental property with that money and certain conditions are met, you may be able to avoid paying capital gains tax at the time of the sale. This is referred to as a 1031 Exchange.
How to calculate capital gains tax on real estate
Calculating capital gains on the sale of property can be done in five straightforward steps:
- Determine the property’s cost basis – Start with the original purchase price then add costs such as closing fees and improvements.
- Identify the selling price – This is the amount you receive upon the sale of the property.
- Subtract the cost basis from the sale price – The difference is your capital gain or loss.
- Apply the correct tax rate – Short-term gains (property held less than a year) are taxed at your regular income tax rates. Long-term gains (property held over a year) are taxed at preferential capital gains rates—0%, 15%, and 20%.
- Factor in deductions or adjustments – Eligible expenses, depreciation recapture, and exclusions may adjust the final taxable gain.
Strategies to minimize capital gains tax on a home sale
Selling real estate doesn’t always mean a heavy tax bill. With the right financial strategy, you can keep more of your profits.
Tax-loss harvesting techniques – Capital gains on real estate can be offset by selling other assets at a loss in the same tax year. This practice is known as tax-loss harvesting. For example, if you are disposing of stocks whose value has dipped below their purchase price, some of that loss can be used to reduce your total gains.
Timing the sale for tax efficiency – Long-term gains tend to have a lower tax rate than short-term gains. If you can hold a property for more than a year before selling it, you may be able to take advantage of a more preferential tax rate. Also, if your income tends to fluctuate, selling property in a year when your income is lower could put you in a lower tax bracket and reduce your capital gains tax rate.
Capital gains on real estate FAQs
No special age-based exemption exists for capital gains. Seniors pay at the same rate as everyone else and may take advantage of the general exemptions that apply to their income level and filing status.
If the house is inherited, you shouldn’t have to pay tax when you inherit it because of the stepped-up basis. This means you won’t be on the hook for any appreciation that took place between the purchase by the original owner and the time of their death. Capital gains tax will apply if you sell the house in the future, but the stepped-up cost basis will still shield you from any unrealized gains the original owner may have experienced.
If you sell your primary residence, where you lived for at least two of the past five years, and meet certain conditions, you may be able to exclude portions of the gain from taxation, based on your filing status.
The cost basis is the amount you paid for the property, which includes closing costs and improvements. In the case of an inherited property, the cost basis is the fair market value at the time of the original owner’s death.
Yes, closing costs are added to the cost basis of a property, which is then used to calculate capital gains.
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Neither New York Life Insurance Company nor its Agents offer personal tax advice. Please contact your tax adviser to find out how the general concepts in this article may or may not apply to your personal circumstances.