Are Real Estate Sales Taxed as Capital Gains?
When you sell real estate, you may wonder if the proceeds are taxable as capital gains. The answer largely depends on whether the property is your primary residence or an investment property, how long you’ve owned it, and if you meet IRS exemption criteria.
Understanding Capital Gains on Real Estate Sales
A “capital gain” occurs when you sell an asset for more than you paid. In real estate, this is generally the difference between the sale price and your cost basis, which includes the original purchase price plus costs like significant improvements and closing fees.
Capital gains taxes apply when you sell property at a profit. The rate at which these gains are taxed is determined by:
- Holding period: Properties held over a year are taxed as long-term capital gains, typically at rates between 0% and 20%, depending on income levels.
- Property type: Gains on a primary residence may qualify for exclusions, while second homes or rentals usually don’t.
Primary Residence Exclusion
For most homeowners, primary residences are eligible for a substantial capital gains tax exclusion:
- Single taxpayers: Up to $250,000 of profit may be excluded.
- Married couples: Up to $500,000 of profit may be excluded.
You must have owned and lived in the home for at least two of the last five years to qualify. Exceptions apply for significant life events, such as a job relocation, which may allow a partial exclusion even if the full requirements aren’t met
Short-Term vs. Long-Term Gains
The IRS distinguishes between short-term and long-term capital gains:
- Short-term gains: If you sell a property held for one year or less, profits are taxed as ordinary income, ranging from 10% to 37%.
- Long-term gains: Properties held for over a year qualify for long-term capital gains rates of 0%, 15%, or 20%, depending on your income bracket
Capital Gains on Investment Properties
Investment properties are subject to capital gains taxes without the exclusions available to primary residences. Moreover, depreciation recapture applies, which taxes the gain at a higher rate (up to 25%) for the depreciation taken during ownership. This recaptured amount is taxed before applying standard long-term capital gains rates to any remaining gain
Using 1031 Exchanges to Defer Taxes
A1 you’re change allows you to defer capital gains taxes if you sell investment property. By reinvesting the proceeds into a “like-kind” property within a specific timeframe, you won’t pay taxes until you sell without using a 1031 exchange. This strategy is useful for real estate investors looking to continue building their portfolios without immediate tax liabilities.
Tips for Reducing Capital Gains Tax
- Home improvements: Substantial improvements to your home increase your cost basis and reduce the taxable gain. These can include renovations such as adding a deck or upgrading a kitchen.
- Selling strategy: If you have flexibility in timing, consider holding the property long enough to qualify for long-term rates. Similarly, primary residence exclusions apply only after meeting the two-year ownership and usage criteria.
- Tracking expenses: Keep records of all significant repairs and improvements. This helps calculate your adjusted basis accurately, potentially reducing your tax burden upon sale.
State and Local Taxes
In addition to federal capital gains taxes, state and local governments may also tax real estate gains. Rates vary widely, so it’s wise to consult local tax guidelines or a tax advisor to ensure compliance with federal and state tax laws.
Final Thoughts
Real estate sales can bring substantial profits but also tax obligations. By understanding IRS rules for capital gains, homeowners and investors can optimize tax savings and keep more from their real estate gains.
