How Capital Gains Tax on Real Estate Works
Capital gains tax is one of the most overlooked expenses you’ll need to pay on a real estate transaction.
Selling a house can be a huge windfall for homeowners, especially if you’re looking to fund your next home purchase. But the proceeds from a home sale don’t all go to the seller. Real estate agent commissions, property taxes, lender fees — there are a lot of closing costs that cut into your profit.
Capital gains tax is one of the most overlooked expenses you’ll need to pay on a real estate transaction. Want to avoid getting blindsided by taxes when you sell a house? Then read up on capital gains tax so you know what to expect.
What is capital gains tax?
Capital gains tax is a tax people pay when selling investments that have grown in value. This type of tax is usually associated with selling stocks or bonds, but it’s not limited to those investment vehicles alone. Real estate can be just as lucrative an investment as any stock, and homeowners may need to pay capital gains tax when you sell your house.
Whether you’re talking about treasury bonds or a single-family house, the idea behind capital gains is the same: Any growth in value that happens over time is purely hypothetical until you sell that asset. And that’s when the taxman is going to come calling, no matter what type of house you own.
You might think capital gains is only something the upper crust of society needs to worry about, but if your property has appreciated in value since you bought it, you could be on the hook for this tax. If you have any doubts at all about your capital gains tax liability, reach out to a tax advisor to see what, if anything, you owe.
Capital gains tax on real estate: How it works
The key idea to keep in mind here is that capital gains tax focuses on the appreciated value of an investment, not its total value. The phrase “capital gain” refers to the profit you make from the sale of any investment or asset.
What does that mean for capital gains on real estate? First of all, you don’t pay capital gains tax on the full sale price of your property. Only the difference between your sale price and your original purchase price — also known as the “basis” or “cost basis” — is taxable.
Say you bought your current house in 2010 for $300,000. Since then, your home’s market value has gone up to $500,000, so it’s appreciated in value by $200,000 — that’s your capital gain. If you sold the property, you would pay capital gains tax on that $200,000 difference in value rather than the full sale price of $500,000. As with any matter related to taxes, it’s best to speak with a professional tax expert so you can fully understand what you owe and what your options are.
Not everyone needs to pay capital gains tax on a house sale, though. In fact, you may be able to take advantage of capital gains exemptions to avoid this expense altogether. But, we’ll get into those exemptions in just a moment.
When do you pay capital gains tax?
Because capital gains can only be assessed when an investment is sold, you pay this tax when selling property to another party. It’s not part of your monthly mortgage payments like property tax. And even though it’s applicable when selling a home, you don’t pay this tax as part of your closing costs. However, the next time tax season rolls around, you’ll need to report your home sale to the IRS and pay whatever taxes you owe on the property.
The nature of the property transfer can dictate when capital gains tax is due as well. If you inherit a house from a family member, for instance, you wouldn’t be required to pay this tax, even if the market value had increased significantly since it was originally purchased. In fact, the property’s cost basis would “step up” to reflect the current value. So, if you sell the house later on, you would use that updated basis instead of the original value.
You also don’t need to worry about capital gains if you’re buying a house, at least not yet. If you plan to sell your new home sometime down the road, though, you’ll have to consider the tax implications of that transaction. Don’t hesitate to ask a tax advisor for help if you’re confused at all about your tax liability.
How much is capital gains tax?
Capital gains tax is calculated as a percentage of an asset’s taxable value. Like income tax, that percentage varies depending on your income and your filing status. There's an extra wrinkle to consider, though: How long have you owned the asset — i.e., your house?
Capital gains are grouped into two categories: short term and long term. Short-term capital gains apply to sold assets you’ve held onto for under a year. Long-term capital gains refer to anything you’ve owned for a year or more.
So, house flippers and real estate investors are more likely to pay short-term capital gains tax, whereas long-term capital gains tax usually applies to homeowners selling a primary residence. As you may have guessed, short-term capital gains tax rates tend to be a bit higher than long-term rates for people with the same income levels and filing statuses.
Long-term capital gains tax rates
What percentage is the capital gains tax for most people selling long-term investments? According to the IRS, the average taxpayer will probably fall into the 15% capital gains tax bracket. That being said, capital gains rates can run as high as 20% on real estate transactions.
Here’s a closer look at long-term capital gains tax rates for 2021, according to Kiplinger:
Single filing status
$40,400 or less: 0%
$40,401 to $445,850: 15%
$445,851 or more: 20%
Married filing jointly
$80,800 or less: 0%
$80,801 to $501,600: 15%
$501,601 or more: 20%
Short-term capital gains tax rates
How much is short-term capital gains tax? Similar to long-term capital gains, tax rates for assets sold within a year of ownership depend on your income level and filing status.
The Motley Fool compiled 2021 short-term capital gains tax rates according to your reported income:
Single
$9,950 or less: 10%
$9,951 to $40,525: 12%
$40,526 to $86,375: 22%
$86,376 to $164,925: 24%
$164,926 to $209,425: 32%
$209,426 to $523,600: 35%
$523,601 or more: 37%
Married filing jointly
$19,900 or less: 10%
$19,901 to $81,050: 12%
$81,051 to $172,750: 22%
$172,751 to $329,850: 24%
$329,851 to $418,850: 32%
$418,851 to $628,300: 35%
$628,301 or more: 37%
You may have noticed a few important details about short-term capital gains tax rates. First, the lowest rate is 10%, no matter what your income level is. Unless you qualify for an exemption, you’ll owe at least something for this type of asset. Second, there are a few places where the rate jumps — notably from 12% to 24% and then 24% to 32%.
Finally, you’re more likely to pay a higher rate with this type of capital gains compared with one you’ve held onto for a longer period of time. In many cases, capital gains tax on primary residences are lower since most people in that situation would have lived in the home for multiple years. Check with a qualified tax expert to see what status your property falls under and what you rate you should expect to pay.
Are there any capital gains tax exemptions?
Homeowners are always on the hunt for tax breaks. And as noted earlier, you may be able to take advantage of capital gains exemptions to reduce your tax liability. According to the IRS, by doing so, you could avoid paying capital gains tax on the property. You just need to meet any of the required qualifications:
You have used your property as your primary residence for at least two out of the five years leading up to the sale.
The capital gains from your home sale — remember, that’s the profit, not the total purchase price — is under $250,000. That figure only applies to people filing as a single homeowner.
If you’re filing jointly as a married couple, that capital gains exemption goes up to $500,000. It’s important to note that if your profit is higher, then you would only pay tax on capital gains above that limit. Let’s say you made $600,000 profit selling your primary residence as a married couple. You would owe capital gains tax on $100,000 of that money.
There are other, far more complicated exemptions that you may be able to use to minimize your tax liability on real estate — particularly on investment properties. However, you would be better served speaking to a qualified tax professional to learn more about anything related to taxes.
In conclusion
Capital gains tax is due on any home sale that turns a profit for the homeowner. Tax rates depend on a variety of factors, including how long you’ve owned the property, your income tax bracket and your filing status.
In general, taxpayers should expect to owe less for capital gains on a primary residence compared with investment properties or house flippers. Also, in many cases, homeowners find that they qualify for capital gains exemptions and don’t need to pay anything at all on a home sale.
Even so, you’ll want to consult a tax advisor who can give you expert guidance on all things related to capital gains. It doesn’t matter what side of the mortgage process you sit on, either as a buyer or seller, you should always cover your bases when dealing with questions about taxes.