For an investor, nothing’s more deflating than the prospect of paying capital gains taxes on their property sale. In some cases, capital gains can eat up the majority of a sale’s profits, and the formula used to calculate capital gains can be extremely confusing to anyone who’s not a tax professional. So what is capital gains, and how, exactly, is it assessed?
When you sell an investment property, the IRS takes a cut of your profits— that’s capital gains, in a nutshell. But the IRS also allows for generous capital gains tax exemptions, both for couples and individuals. If you’re lucky, your profits will be covered by one of those exemptions. But if your property has skyrocketed in value while you’ve owned it, you may have a hefty tax bill.
Let’s look into how capital gains are calculated, how the capital gains tax exemptions work, and some ways you can legally avoid or reduce your capital gains taxes.
Table of Contents
- What Are Capital Gains in Real Estate?
- Capital Gains Tax Exemptions
- Here’s When You’ll Pay Capital Gains Taxes
- How to Calculate Capital Gains Taxes
- The Capital Gains Tax Rates
- How to Avoid Capital Gains Taxes
- Find a Top-Rated Agent
What Are Capital Gains in Real Estate?
To put it simply, a capital gain is profit from the sale of a capital asset.
That definition probably sounds a little circular, so we’ll clarify. A capital asset is anything you own that you don’t use as a business or trade asset. Essentially, that includes almost everything you own— from property like your home and car, to investments like stocks and art. When you sell any of those capital assets, any profit you pocket is a capital gain, and that’s taxed at capital gains tax rates.
On the other hand, if your asset has depreciated in value, and you take a loss, that’s a capital loss. We’ll delve into capital losses, and how they can work for you, later in this guide.
Your capital gains are taxed differently than income you earn from working, like salaries, tips, or bonuses. This ordinary income is subject to ordinary income tax rates, which are usually higher than capital gains tax rates.
Why are capital gains such an important topic in real estate? Well, for the vast majority of taxpayers, their home is their most valuable capital asset, and selling it brings most people their first capital gains tax bill— and maybe their biggest tax bill of any kind, ever.
Luckily, the IRS provides generous exemptions on your primary home. That means that, if you sell the home you live in most of the time, you can probably avoid most or all capital gains taxes. However, if you sell an investment property, you’ll probably be hit with a capital gains tax.
Let’s go over the exemptions, and the definitions of your primary residence, and of an investment property.
Real Estate Capital Gains Tax Exemptions
If the home you’re selling is the one you’ve lived in and owned for at least two of the last five years, you’re eligible for a capital gains tax exemption under the primary home rule.
If you’re single and you file taxes individually, you can exclude up to a $250,000 gain on your primary home.
If you’re married and you file taxes jointly, you can exclude up to a $500,000 gain on your primary home.
Let’s look at a couple of examples to see how it works in practice. If you’re a single person, and you bought a home five years ago for $250,000, lived in it for at least two of the last five years, and are now selling it for $500,000, you don’t have to worry about capital gains ($250,000 is your profit, and all of that money is exempt).
If you’re a married couple, and you bought a $500,000 home five years ago, have lived in it for at least two of the last five years, and are now selling it for $1 million, your gain is fully exempt from capital gains taxes.
So when are you subject to capital gains taxes?
Here’s When You’ll Pay Capital Gains Taxes When You Sell a House
If Your Home Has Appreciated Dramatically
Those $250,000 and $500,000 exemptions sound very generous, but in the hottest markets it’s easy to exceed those numbers, even if you’ve only owned your home for a decade or so.
So if you bought an average house in the average D.C. neighborhood a decade ago, and sold it today, you’d be just over the capital gains tax exemption. If you did better than average, you’d be well into capital gains tax territory.
Your Home Has Appreciated Steadily— Over a Long Period of Time
If you’ve owned a house— or you’ve inherited a house— that was purchased decades ago, it’s likely appreciated quite a bit, even if it’s located in a cooler market.
Selling a home that’s been in your family for a long time can very easily exceed the capital gains tax exemptions, especially if it’s in a market that’s been hotter than average.
You’re Selling an Investment Property
This is the big one. Remember how the property tax exemptions discussed above specifically defined your primary residence as one you’ve lived in for at least two of the previous five years? If the property you’re selling is an investment property, it’s almost certainly going to be subject to capital gains taxes.
How to Calculate Capital Gains Taxes When Selling a House
The first step in assessing your capital gains is to calculate your cost basis.
Put simply, the cost basis is the price you paid for the property, with the cost of repairs and improvements taken into account. You’ll also have to account for any depreciation you claimed.
A solid cost basis formula looks like this:
Original cost + cost of improvements + cost of repairs – depreciation = adjusted cost basis
Let’s say you bought a $300,000 rental property, and you’re selling after five years; the formula might look like this:
$300,000 + $15,000 (new kitchen) + $12,000 (roof repairs) – $50,000 (depreciation) = $281,000
So $281,000 is your adjusted cost basis. If you’re selling the property for $360,000, you’d plug that basis into this formula to calculate your capital gains (or losses):
Sale price – (commissions, legal fees, and marketing fees paid during sale) – adjusted cost basis = capital gain or loss
So using the example above, the numbers could look like this:
$360,000 – $23,000 (commissions, etc.) – $281,000 = $56,000
So you’re left with a capital gain of $56,000 on this investment property. In this case, our example assumed you owned for five years, so it would be taxed at the long-term investment rate— but if you’d owned for less than a year, you’d be taxed at the short-term investment rate. Let’s touch on the differences between short-term and long-term capital gains here.
Short-Term Capital Gains Tax Rate
If you own an investment property for less than a year— if, for example, you’re a house flipper— those capital gains are going to be classified as short-term, and will be taxed as ordinary income.
Long-Term Capital Gains Tax Rate
If you owned this investment property for more than one year, those capital gains will be taxed at the capital gains rates. This is generally a much more favorable rate than the ordinary income rate.
The Capital Gains Tax Rates
Capital gains tax rates are actually very straightforward; your capital gains are taxed at either 0%, 15%, or 20%. Which rate you pay is based on your income. The chart below shows the income limits for taxpayers filing individually, and jointly:
|Tax Rate||Filing Single||Filing Jointly|
|0%||Up to $40,000||Up to $80,000|
|20%||Over $441,451||Over $496,601|
For clarification and more details, consult the IRS website.
How to Avoid Capital Gains Taxes When Selling Your House
Even if your property doesn’t meet the definition of a primary residence, and is going to be taxed as an investment property, there are some easy (and totally legal) ways to avoid capital gains taxes.
Offset Your Gains with Losses
When it comes to capital gains, the IRS takes a somewhat holistic view of your situation. So if you’ve taken a capital loss during the same year that you’ve incurred capital gains tax exposure, your losses could potentially offset your gains.
For example, if you sold an investment property for a $500,000 profit, but you lost $600,000 on the stock market, those stock losses cancel out the capital gains you would’ve owed on the investment property sale. A bittersweet perk of taking big investment losses, but one you shouldn’t overlook.
Use a 1031 Exchange
The 1031 exchange is an obscure provision of the tax code that can be a massive boon to real estate investors.
A 1031 exchange essentially allows you to trade one investment property for another, while deferring capital gains on the initial property sale. The rules of the 1031 exchange are pretty simple— you simply have to use the proceeds from the initial sale to purchase a “like kind” property within 180 days.
“Like kind” sounds more restrictive than it actually is; you just have to be buying a similar income-producing property. So you can sell an apartment and buy a single-family home, or sell a single-family home and buy a commercial property. After the initial sale, you have 45 days to identify properties you could potentially buy, and then close within 180 days. But be careful— if you miss this deadline, even by just a day, you’ll be hit with the full capital gains tax bill.
The best part of the 1031 exchange? You can use it repeatedly, deferring capital gains each time. So an investor could potentially go from a rental apartment, to a single family home, to a full apartment building, and wouldn’t have to pay capital gains on any of those sales until they sold off the apartment building. It’s a great way to build up a real estate portfolio and reinvest your profits while avoiding the pain of paying capital gains.
Turn Your Rental Property Into a Primary Residence
If you want to sell your rental investment property, converting it into your primary residence for a couple years prior to selling can have huge tax benefits.
Living in a property you own for at least two of the previous five years qualifies it for the primary residence capital gains tax exemption— but it’s not a binary, either-or situation.
Let’s say you own a rental property, rent it for three years, and then live in it for two years before selling. Those two years of primary residency do not wipe out those three years of use as an investment property. They simply exclude two-fifths of your capital gains (for the two years, out of five, that you lived there); when you sell, you’ll have to pay capital gains on the remaining three-fifths of your profit.
Find a Top Agent With Investing Expertise
Calculating capital gains can be a dizzying experience, especially for novice investors. It helps immensely to have a dependable tax professional to help you, as well as a real estate agent who understands the tension between leveling up your investments, and keeping an eye on your capital gains situation.
Real Estate Witch has partnered with Clever Real Estate to help our readers connect with just this type of agent.
Clever partners investors with seasoned local real estate agents with proven track records— the type of agents who can advise you on every aspect of your investments, from procuring new investments, to timing the market on your sales, to the all-important question of how to manage your capital gains tax liability. Contact Clever today to get started on your real estate investment portfolio!