Selling a home for more than you paid may sound like a straightforward win and it usually is, but the IRS may want a portion of the profit. And understanding exactly how much, when and whether you can reduce or eliminate it is critical before you close your deal.
What is capital gains on property sale is a question every seller should be able to answer before you even plan on selling your primary residence.
Capital Gains Tax on Real Estate: The Basics
So, what is capital gains on property sale?
Capital gains tax is the tax that is owed on the profit from selling a property, particularly the difference between what you paid for it and what you sold it for. When you sell an asset like a home, that profit from the sale is called a capital gain and depending on how long you owned your property and how much you made, you may owe capital gains tax to the federal government.
Calculate Capital Gains Tax: How It Works
It can either be short-term or long-term, subject to capital gains tax depending on the duration of ownership.
- Short-term capital gains are applied if you own the property for one year or less before selling. These are taxed at your ordinary income tax rate and are the same as your regular income tax & can be significantly higher than long-term rates.
- Long-term capital gains apply when you have owned the property for more than a year. Long-term capital gains tax rates are 0%*, 15%* or 20%* depending on your tax bracket and filing status and are far more favorable than short-term gains rates, making it essential to understand your original purchase price.
For most homeowners who have lived in their primary residence for many years, the long-term capital gains tax rate applies and the conditions that show can provide significant
The Home Sale Tax Exclusion
The home sale tax exclusion under the IRS section 121 is one of the most powerful tools available in the market for people selling their primary residence because it allows you to exclude a significant portion of your profit from your taxable income entirely.
- Single filers can exclude up to $250,000* capital gains from the home sale.
- On the other hand, married couples filing jointly can exclude up to $500,000*.
In order to qualify for the exclusion & reduce your capital gains rate:
- The property must be a primary residence and not a vacation home or any type of investment property.
- You must have lived in the home for at least two of the five years before you sell.
- You cannot have used the exclusion for another home sale in the past two years.
- And lastly, the property cannot have been purchased through a 1031 exchange in the past five years, which could affect your ability to defer taxes.
Exclusion of capital gains under this rule is not automatic and you must meet all conditions. If only one spouse meets the 2-year ownership test but both meet the residency test, the exclusion can still be used when filing jointly.
Taxes on Real Estate: Investment and Rental Properties
It is important to note that the exclusion only applies to your primary home. For investment properties, vacation homes as well as rental properties, different tax rules may apply.
When you sell an investment property, you will pay capital gains tax on the full profit from the sale. There are no exclusions available. Whether you pay capital gains at the short-term or the long-term capital gains tax rate will depend entirely on how long you held the asset.
Tax on a home sale for investment properties can also include depreciation recapture, which is a portion that is taxed at up to 25%* for previously claimed depreciation deductions. This is one area where working with a tax professional before you sell a home is strongly recommended.
Conclusion
So, the answer to the question “what is capital gains on property sale” ultimately comes down to this: the profit you make when selling real estate may be taxable, but for most primary residence sellers the exclusion covers the gain entirely. For investment properties the picture can be a bit more complex and the tax bill more significant.
The key is actually knowing your situation and whether you can defer taxes before you plan to sell your home. Make sure to consider if you are eligible for exclusion, what are your selling costs and if you have tracked your capital improvement investments. All these answers can directly affect how much tax you owe.
Understanding the rules around taxes when selling real estate can save you thousands of dollars. At Nitin Austin Realtor, we have been working with buyers and sellers across the Austin market in order to help them understand every aspect of a home purchase and sale, be it pricing strategy or financial implications of a transaction. So, make sure to contact our local experts before you get started.
Also Read: What Are the Hidden Costs of Buying a House? Complete Guide for Buyers
Frequently Asked Questions
Do you always need to pay capital gains tax when you are selling a home?
No, not always – single filers can exclude up to $250,000 of profit & married joint filers up to $500,000* – but this depends on the number of years you have used it as your primary residence.
What is the capital gains tax rate on a real estate property?
Long-term capital gains tax rates are around 0%*, 15%* or 20%* which depends on your income and filing status, whereas, short-term gains from properties held under 1 year are taxed at their ordinary income rates.
Can someone avoid capital gains tax by buying another home after selling?
No, because the old “rollover” rule no longer exists & the only way to avoid capital gains on a primary residence sale is via the Section 121 exclusion and not by purchasing another property.
