If you’re like most Americans, then your home is your greatest asset. Owning a home is a great way to increase your wealth over time. In fact, according to the National Association of Home Builders (NAHB), the average net worth of people who own homes, about $255,000, is roughly forty times as much as those who rent (with an average net worth of about $6,300).
If you’ve ever sold an asset for a profit before (like stocks), then you may have had to pay capital gains tax. These taxes apply to a wide variety of profit-yielding assets, though it can appear unclear if you have to pay capital gains tax for specific real estate transactions. In most cases, unless you generate a significant profit from a home sale or are selling a property that is not your primary residence, then you won’t need to pay capital gains tax. However, there are many nuances that can apply to the capital gains generated by selling a property, which is why it is important to understand how exactly these taxes work.
What is the Capital Gains Tax?
Capital gains taxes apply when a party (such as a homeowner or an investor) sells a capital asset for a profit. These taxes only occur when capital gains are realized, typically once you complete a sale. This means that even if the asset you are holding (home, stocks, etc.) measurably increases in value, you won’t need to pay these taxes until a sale has occurred.
Capital gains account for the nominal change in an asset’s value, meaning they don’t account for inflation (which is known as the “real” value of the asset). As of the summer of 2022, the capital gains tax rate in the United States is 15 percent for all taxpayers whose income is above $40,400 and below $445,850. Earners below this range don’t have to pay any capital gains taxes, while those above this range pay 20 percent.
How capital gains taxes work
Suppose you invest $20,000 in a specific stock, and over time, your stock ownership grows to $30,000. If you choose to sell the stock, at that point, you will have earned $10,000 in nominal profit—in other words, you will have made $10,000 in capital gains. Given the 15 percent capital gains tax rate that applies to most taxpayers, this means you will owe $1,500 in capital gains taxes.
Even in this simplified example, there are a few important variables to consider. First, you must hold these stocks for at least one year for them to qualify for the “long-term” capital gains tax—otherwise, these gains will be treated as ordinary income, and you will likely pay more than 15 percent in taxes. Secondly, if you also sold some long-term investments at a loss in the same tax period (typically a year), you could write off your capital losses to reduce your capital gains obligations.
Capital gains generated via real estate investments are sometimes treated differently than those generated via stocks and other equities due to the Taxpayer Relief Act(1997).
The Taxpayer Relief Act of 1997
The Taxpayer Relief Act of 1997, signed by then-President Bill Clinton and generally supported by both main parties, offered a wide range of relief from capital gains, most notably from people who generated capital gains when choosing to sell their primary residence.
In short, the Taxpayer Relief Act made homeowners who sold their homes in the last year exempt from paying capital gains taxes. This helped ordinary homeowners profit from selling their homes without immediately owing a significant tax bill.
The Act established two general cut-offs for which people selling their homes would be exempt. Any filer who exceeds the cut-off must pay capital gains. For single tax filers, the capital gains tax kicks in at $250,000. For married couples, the cut-off is $500,000.
Furthermore, the Act also specified that a capital gains tax exemption only applies to someone’s primary residence. Additionally, there are limits to often you can actually claim this capital gain exemption. Most homeowners can only claim it once every two years, though, as you will pretty much always find when it comes to taxes, there are exemptions to this general rule.
Do Capital Gains Taxes Apply to Real Estate Sales?
To summarize, if you sell your home and realize a capital gain as a result (meaning you sold your home for more money than you initially paid for it), you will not pay capital gains tax. That is unless you cannot qualify for the full protections afforded by the Taxpayer Relief Act of 1997.
If you sell your home and receive a capital gain greater than $500,000 if you are married or a $250,000 capital gain if you are single, you will need to pay capital gains tax on all gains beyond the cutoff. Additionally, if the home is not your primary residence, then you will pay full capital gains. Even if the home is not an “investment property,” you must be mindful of where the IRS considers your primary place of residency.
How Does the IRS Determine Your Primary Residence?
As a general rule of thumb, the IRS considers your primary residence to be the address associated with where you file your taxes. There are of course, exceptions to this rule.
The 2-in-5 Year Rule
The IRS often uses the “2-in-5 Year Rule” to establish your primary residence. This rule means that anywhere you’ve lived for two years (aka 730 days) within the past five years (aka 1,825 days, yes, they don’t account for leap day), is a place that you can consider your primary residence if you choose to.
There may be situations in which you’ve spent a qualifying amount of time at two different places during the standard five-year window. For example, if you own homes in multiple states, you might qualify to claim either as your primary residence. Suppose you spend every October through April in California and every April through October in New York—in that case, both locations could be considered your primary place of living.
If this or similar cases describe your current living situation, then you may consider speaking with a tax attorney or accountant to determine which home you should claim as your primary residence. If you are thinking of selling one of these properties, you may want to consider making that one your primary residence for the time being in order to avoid capital gains taxes once you choose to sell. If you’re paying a 20 percent capital gains rate on a home that produces $500,000 or more in capital gains, this decision could potentially save you up to $100,000 in taxes.
Modifications to the Capital Gains Tax
An exemption on real estate capital gains can only be claimed, at most, once every two years. If you are moving around a lot, you might not be able to claim the capital gains tax exemption, even if your gains fall below the current cut-off.
Additionally, it is also important to note that if you make material investments in your home to sell it, many of these investments could be written off in the future. This might help lower the possible capital gains you’ve earned when selling your home, perhaps enough to completely exempt you from the capital gains tax altogether. For example, if you invested $50,000 in the home before you decided to sell it and you and your spouse earned $520,000 in capital gains, you could write these gains down to $470,000 (essentially classifying the home improvements as a “capital loss”), meaning you will no longer have to pay the capital gains tax.
Capital Gains Tax Exemptions
There are quite a few other exemptions and modifications. If you sold other sources of capital (like stock) for a loss, you could use those losses to lower your total obligations. This is why people will often sell and “write off” seemingly irredeemable stocks the year they plan to sell their primary residence. Additionally, it is also important to note that if your sale is subject to expatriate taxes (applied to non-citizens), you will also not be eligible to access the exemption.
How to Calculate Your Capital Gains Tax
Finally, let’s look at a few examples of how you might determine your real estate capital gains taxes.
Example One
Suppose you bought your home for $200,000 and are about to sell it for $1 million. Your household income is $100,000, and you have made no other capital gains or losses over the course of the past year. You’re also married and have been living in your home and using it as a primary residence for 20 years.
In this example, your capital gain will be $800,000—the amount your home has increased in value. As a married person, you can claim up to $500,000 in capital gains deductions. Additionally, your income means you will be subject to a 15 percent capital gains tax rate.
Since the sale of your home is $300,000 above the exemption limit, that is the amount of money that will be subject to capital gains taxes. At a 15 percent rate, your final tax bill will be $45,000.
Example Two
Five years ago, you purchased a home for $300,000. You are not married and now looking to sell your home for $500,000.
This one is straightforward, your capital gain of $200,000 is lower than the $250,000 cutoff for non-married people, so you will not need to pay any capital gains taxes.
How to Avoid Capital Gains Tax
In some situations, homeowners can defer their capital gains taxes. For example, with a 1031 exchange, real estate investors who exchange one property for another can push their capital gains taxes until a later date. To qualify for these deferments, the replacement property must be of a similar value and the buyer must purchase the new home within 180 days of the sale of the first.
Information for Investors
Property investors can find opportunities to minimize their tax obligations. For example, if the property’s value depreciates, they can potentially decrease their taxable income with a depreciation write-off. Additionally, they can use any other capital losses (such as stock losses) to offset some capital gains. Investors may consider selling negative stock whenever they also sell a property.
Conclusion
Now that you have taken the time to understand how capital gains taxes work in the world of real estate, you’ll be better prepared to calculate how much you will really make when selling your home. While the existence of these taxes might not affect your final decision on whether to buy or sell, they are certainly something to keep in mind when considering the total cost of acquiring a new home.
