At a Glance
Main Takeaway
Capital gains are the profits received when selling an asset, such as real estate, which can include your home, as well as commercial and rental property. Taxpayers pay capital gains tax based on the period of ownership and, when selling a personal residence, the length of time lived in the home. Other circ*mstances may also affect if and when capital gains taxes are recognized on the sale of real estate property.
Next Step
Learn about capital gains tax and how Windes can help you minimize tax liability when selling real estate.
Capital Gains Tax & Real Estate Basics
With regard to real estate, capital gains tax liability varies based on the short-term or long-term ownership of an investment or personal property.
Short-Term Capital Gains
The sales of investment or personal property held for less than a year is subject to your marginal tax rate.
For the 2023 tax year, marginal tax rates fall between 10% and 35%. Single taxpayers earning more than $578,125 or married couples earning more than $693,750 will pay the top tax rate of 37%.
Long-Term Capital Gains
Taxpayers who have owned the property for more than one year may have to pay capital gains taxes on profits made from a sale.
Capital gains tax rates can range from 0% to as high as 28% (for assets such as collectibles); however, 20% is the most common capital gains rate for most situations. Single taxpayers earning less than $40,400 or $80,800 if married and filing jointly will not incur capital gains tax.
For single taxpayers earning above the thresholds of $445,850 or $501,600 for married and filing jointly, the tax rate on gains is 20%. Taxpayers can expect a 15% capital gains tax if their income is between $40,400 and $445,850 as a single taxpayer or $80,800 and $501,600 for married and filing jointly.
If an individual has income from investments, the individual may be subject to net investment income tax. Effective Jan. 1, 2013, individual taxpayers are liable for a 3.8% net investment income tax on the lesser of their net investment income, or the amount by which their modified adjusted gross income exceeds the statutory threshold amount based on their filing status. The net investment income tax of 3.8% is in addition to the taxpayer’s highest capital gains tax rate.
The statutory threshold amounts are:
- Married filing jointly – $250,000,
- Married filing separately – $125,000,
- Single or head of household – $200,000; or
- Qualifying widow(er) with a child – $250,000.
Additionally, net investment income does not include any gain on the sale of a personal residence that is excluded from gross income for regular income tax purposes. To the extent the gain is excluded from gross income for regular income tax purposes, it is not subject to the net investment income tax.
Example: If a taxpayer earns income from rental properties owned or capital gains from selling investment properties and the adjusted gross income is over $200,000 for single or head of household, or $250,000 for married and filing jointly, you may have to pay a net investment tax in addition to capital gains taxes.
How to Evaluate Your Tax Basis for Capital Gains
If a taxpayer sells or exchanges property, the taxable capital gain generally equals the value received minus the property’s cost-basis value. For tax purposes, the basis of the property is the amount a taxpayer initially invested.
When selling a primary home, the taxpayer needs to know the price realized and the adjusted basis. The adjusted basis is the property’s basis value, plus or minus improvements made to the property or other costs, such as zoning fees, for maintaining the home.
To calculate gains on the initial tax basis, use Worksheet 2 on IRS Publication 523. The worksheet covers several steps, including:
- Determining the sale price of the home
- Calculating selling expenses
- Figuring amount realized (sale price minus selling expenses)
- Calculating the total basis
- Determining adjusted basis
- Figuring gain or loss (amount realized minus adjusted basis)
Adding fees and closing costs as part of the selling costs will help determine your tax basis.
Specific updates like home improvements can affect gain or loss. For example, if improvements such as a new roof, carpeting, pipes, or ductwork are made, the taxpayer can include those improvements in the calculation. These renovations will add value to the property and increase its adjusted basis, impacting the amount gained or lost depending on the home’s sale price.
Capital Gains Tax on the Sale of a Primary Home
Meeting specific conditions for the sale of a home can exclude gains up to:
- $250,000 for a single filer
- $500,000 for married and filing jointly
Example: A taxpayer filing single bought a property for $200,000. The property is sold ten years later for $400,000. Based on calculations, the adjusted basis is $300,000. The property sold for $400,000; therefore, the taxpayer has a realized gain of $100,000. Since this falls below the $250,000 exception, the taxpayer can exclude capital gains from taxation.
Would My Home Qualify for an Exclusion of Gain?
A home may qualify for an exclusion of gain under certain circ*mstances. The IRS considers the following conditions to determine eligibility for exclusion on capital gains taxes:
- Ownership. Owning a home for two out of the five years before selling qualifies for the exclusion.
- Residence. Living in the property for at least 24 months out of the past five years can qualify for the exclusion. The 2-year residency can be at different times within the five years.
- Look-back. The taxpayer did not sell another home during the two years before the home’s sale date. If a property was sold in the same period and did not exclude the capital gains tax, the property qualifies for the look-back.
However, according to the IRS, there are exceptions to the eligibility criteria. Taxpayers may qualify for an exception from capital gains tax depending upon the following life situations:
- Separation or divorce. If the taxpayer is the sole owner of the home, the ex-spouse lives in it as part of a divorce agreement, or the property is transferred to the taxpayer, the taxpayer can count any period that the spouse owned it as the taxpayer’s. However, the residency requirement must be met.
- Widowhood. When the 2-year residence and ownership requirements are not met, and the taxpayer has not remarried at the time of the sale, the taxpayer can include any time the deceased spouse owned and lived in the home.
- Military and Peace Corps members. Military and government employees on extended duty may suspend the 5-year requirement for ownership and residency. The 2-year residence requirement may apply even if the taxpayer was away from the home in the 24 months during the five years ending on the home’s sale date.
Conditions for Partial Exclusion from the Capital Gains Tax
If a taxpayer does not meet the IRS eligibility tests, they may still qualify for a portion of the capital gains exclusion. The portion eligible equals the time the taxpayer used the home as their residence during the two years. The following conditions may allow a partial exclusion of capital gains if it is sold before the 2-year requirement:
- Job-related moves. These moves include transferring to a new work location at least 50 miles from the primary residence.
- Health issues. A health issue can necessitate moving or providing medical care to a family member, or a doctor may recommend the move due to a health issue.
- Unforeseeable events. Cases of destruction, natural disasters, and changes in family status, such as the death of a property owner or the birth of two or more children from the same pregnancy.
Tax-free gains on home sales up to $250,000 for singles and $500,000 if married and filing jointly are available if you qualify for an exclusion.
Example: A couple sold their house for $785,000 in December 2022 due to an out-of-state move for a new job. They originally bought the home for $700,000 in 2020 and have lived there for 15 months.
Based on the $500,000 exclusion allowance, the couple could multiply $500,000 by .625 (15/24 months, the percentage of time they lived in the home out of the two years) to get a maximum exclusion of $312,500. Since they only made $85,000 in gains on the sale ($785,000 minus $700,000), they can exclude the full amount.
Capital Gains Tax and Vacation Home Sales
The IRS considers a vacation home a capital asset, making it taxable under normal capital gains rules. Vacation homes do not qualify for capital gains exclusions. If a taxpayer sells a vacation home for a profit and meets the income and ownership requirements, they will pay capital gains taxes on the sale.
Example: A taxpayer purchased a vacation home in 2015 for $600,000. The property’s adjusted basis is $650,000. The home sold for $800,000. The taxpayer will incur $150,000 in capital gains, which is taxable at the marginal income bracket’s capital gains tax rate.
Converted Vacation Homes and Capital Gains Taxes
If a vacation home is converted into a primary residence and the taxpayer will live there for at least two years, they still may not qualify for the full capital gains tax exclusion when sold. Capital gains taxes must be paid for the portion of time the home was used as a vacation property. However, the taxpayer may qualify for a reduced exclusion for the period lived in the home as their primary residence.
Capital Gains Tax on Real Estate When Selling Rental Property
If rental property owned is sold for a profit, the taxpayer must pay applicable capital gains taxes. Selling rental properties follows the same rules as vacation homes; the taxpayer pays capital gains tax rates on rentals sold after at least one year of ownership, based on the taxpayer’s income and filing status.
However, if depreciation deductions were taken on a rental property owned for more than one year, the taxpayer must recapture the deductions on their income and pay taxes at a rate of up to 25%.
Example: A taxpayer purchased a rental property for $450,000 and took $150,000 in depreciation. After five years, the rental property is sold for $700,000. The adjusted basis for the property is $300,000 ($450,000 minus $150,000). The gain made on the property’s sale is $400,000 ($700,000 minus $300,000).
For unrecaptured Section 1250 gains ($150,000 in deductions), the taxpayer will pay the higher capital gains tax rate of 25%. They will pay the regular tax rate for the remainder of the gains, $250,000 ($400,000 minus $150,000).
Capital Gains Tax on Like-Kind Exchanges
Realizing a gain on a personal or business investment property you have owned for over one year triggers a capital gains liability. However, taxpayers may postpone paying tax on the gains under Section 1031 when the profits are reinvested in a similar property through a qualifying like-kind exchange. In Section 1031 transactions, taxes do not need to be paid until you sell the newly acquired business or investment property.
Most real estate properties qualify as like-kind exchanges. Like-kind property refers to a property of a similar character, feature, or nature. For example, selling a rental property to purchase another rental property of similar character is a like-kind exchange.
A like-kind exchange allows a taxpayer to defer part or all the gain triggered by the sale of the exchanged property. The like-kind exchange does not apply to personal real estate properties such as primary residences or vacation homes.
Other conditions must be met to participate in a tax-deferred like-kind exchange:
- There is a 45-day deadline for identifying the new property. The seller must receive a letter identifying the new property within 45 days of the initial transfer of ownership.
- The transfers must take place within 180 days. Taxpayers must receive a like-kind property within 180 days following the transfer or by the tax return due date, including extensions, for the year of the property’s sale date.
What Are the Exceptions for a Section 1031 Exchange?
Avoiding capital gains tax under Section 1031 is not possible in all circ*mstances. For instance, real estate located in the United States exchanged for foreign real estate will not qualify for excluding capital gains taxes as the property is not like-kind. Tax-deferred treatment also does not apply to exchanges involving personal real estate for commercial property.
How to Avoid Paying Capital Gains Tax on Real Estate
You can consider using a buy, borrow, or die tax strategy alternative to minimize tax liability on your balance sheet. There are three components to the strategy:
- Buy – Invest in assets that appreciate over time and earn enough income to cover living expenses, such as rental real estate.
- Borrow – A refinance allows you to generate cash flow. Refinancing the property rather than selling it defers paying 15% to 20% in capital gains taxes. A taxpayer can use the proceeds to improve the property, purchase another, or use them for personal expenses.
- Die – When the owner dies, their estate and beneficiaries do not have to pay income taxes on the appreciation of the assets but may pay estate tax on the basis of the property inherited.
Purchasing assets using this strategy allows one to build wealth over time, tax-free while generating income. You can work with the real estate tax professionals at Windes to apply timely investment decisions and tax planning to reap the benefits of the buy, borrow, die strategy.
Plan Ahead to Save on Taxes with Windes
Consider Windes’ tax planning services to take advantage of capital gains primary residence exclusions and long-term capital gains tax on real estate.
We have technical expertise across various industries and prioritize strong client relationships and customer service. You can count on us to help you minimize tax exposure and grow your personal wealth.
Our tax and accounting services include:
Using Tax Incentives and Credits
We can advise you of the rules of tax-free exchanges and credits to ensure you stay compliant with IRS regulations. Our accountants can answer questions you may have before you decide to use a Section 1031 Exchange.
Estate Planning
The estate, will, and trust accountants at Windes can assist you in saving income and estate taxes. As part of our comprehensive planning process, we ensure that your assets pass to the intended beneficiaries while minimizing tax consequences.
We can help you navigate the process of probating an estate, including filing required documents, managing assets, and paying taxes owed at death. We also offer assistance with trust administration and other fiduciary matters.
Accounting Support
You can delegate time-consuming accounting tasks to Windes and delegate figuring out your tax obligations to trained professionals while you focus on running your business.
Outsourced accountants have the knowledge and experience to help you avoid mistakes that could negatively impact your personal or business finances. Our professionals can advise you on available capital gains deferment and minimization strategies.
Determine Your Capital Gains Tax Strategy with Windes’ Professional Accounting Services
Windes can help you maximize your gains while minimizing your tax obligations when you sell your property. We provide real estate accounting solutions for all your financial, accounting, and tax needs. We help you understand the real-life tax implications and make the most of your real estate investments.
Contact us today to explore ways we can help you lower your capital gains tax liability on real estate.
