Capital Gains Tax on Real Estate: How the Federal Tax Works

Capital gains tax is a federal tax that the US Internal Revenue Service (or IRS) levies on the net capital gain generated by the sale of an asset that has increased in value beyond what the seller initially paid for it (the cost basis). Eligible assets for capital gains taxes typically include stocks, collectibles, or real property. When the owner sells the asset, the government qualifies this as income and taxes it at the appropriate capital gains tax rate, depending on the filer’s marital status and income tax bracket.

Short-term capital gains tax rates—which apply to assets owned for less than a year—are higher than long-term capital gains rates—which apply to assets held for a year or more. Short-term capital gains are taxed at the ordinary income tax rate for a given year with almost no exemptions. The long-term capital gains tax treatment allows for a series of exemptions that enable the seller to collect tax-free profit from the sale of their asset. US Tax Code exempts long-term capital gains on a piece of real estate if the profit generated from its sale falls below certain income thresholds or if the seller has lived in the property for two out of the last five years instead of using it as a rental property.

Appreciating real estate is a capital asset that qualifies as taxable capital gain if the owner decides to sell it. Here’s how capital gains tax works on real estate:

• Tax bracket determines the rate. The percentage of capital gains tax that you pay on a sold asset varies depending on how much taxable income you make in the given tax year. Short-term capital gains (which act like regular income) are taxed at a higher rate than long-term capital gains. Taxpayers selling long-term assets will pay zero percent, fifteen percent, or twenty percent, depending on the profit from the asset's sale.
  
• Filing status determines threshold. You will also pay a different percentage on your capital gains based on your filing status, whether you're filing as single, head of household, married filing jointly, or married and filing separately.
• Excess over cost basis affects threshold. Any profit you earn above the cost basis of the house (i.e., what you paid for it, including improvements) can be exempt up to a certain threshold. For single filers, the first $250,000 earned on a home sale is exempt from capital gains tax. Married couples receive higher tax benefits; the first $500,000 made on a home sale is tax-free.
• Exemptions for some primary residences. You do not have to pay tax for capital gains on the sale of a home that is your primary residence. According to the IRS, a principal residence is a home that you have lived in for at least two years over the past five years. Small business owners who run many investment properties cannot claim exemptions on capital gains generated from a property sale if they use the property for rental revenue or live in the home for less than two weeks each year.
• Exemptions for different exchanges. You may be exempt from paying capital gains tax on an investment property if you have made a like-kind exchange, selling the investment property in exchange for another similar property, and doing a 1031 exchange.
• Deferment opportunities for certain properties. Buying investment properties in opportunity zones—like low-income areas—can also defer capital gains taxes. You can also lower the tax bill on your home sale by accounting for costs associated with selling the property. These costs may include closing costs after the date of sale, any home improvements, or fees for tax professionals and real estate agents. Capital losses from the same year can also offset the capital gains tax owed on an appreciated investment.

To figure out long-term capital gains tax rates on the sale of your home, real estate investors need to know their tax filing status and income tax rate. Here are some examples of how to calculate capital gains tax on a real estate sale based on income tax bracket and filing status.

• Single filer status: If your income is less than $40,000 a year, you will pay zero percent in capital gains taxes. If you make between $40,000 and $441,450 a year, you will pay fifteen percent in capital gains taxes. If you make over $441,450 a year, you will pay twenty percent in capital gains taxes.
• Married joint-filing status: If your joint income is less than $80,000, you will pay zero percent in capital gains taxes. If you make between $80,000 and $496,600, you will pay fifteen percent in capital gains taxes. If you make over $496,600, you will pay twenty percent in capital gains taxes.
• Married filing separately status: If you make over $40,000 individually, you will pay zero percent in capital gains taxes. With an income between $40,000 and $248,300, you will pay fifteen percent in capital gains taxes. With an income of over $248,300, you will pay twenty percent in capital gains taxes.
• Head of household status: If you make under $53,600 the year of filing, you will pay zero percent in capital gains taxes. With an income between $53,600 and $469,050, you will pay fifteen percent in capital gains taxes. With an income over $469,050, you will pay twenty percent in capital gains taxes.

A single homeowner buys their primary residence at a purchase price of $700,000. After five years, they sell the property for a sale price of $1,100,000, making a profit of $400,000. The first $250,000 is tax-exempt, leaving $150,000 as a tax liability. The homeowner has a gross income of $80,000 a year, meaning they will owe fifteen percent of the $150,000 in capital gains taxes. Of the eligible income made from the home sale, the homeowner will pay $22,500 in capital gains taxes.

All investments, including real estate investments, come with inherent risks which may involve the depreciation of assets, financial losses, or legal ramifications. The information presented in this article is for educational, informational, and referential purposes only. Consult a licensed real estate or financial professional before making any legal or financial commitments.

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