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Tax on Real Estate and Home Sales: A Complete Guide

March 22, 2024

When you sell real estate, including homes, you might need to pay taxes on the profit you make. This profit is known as “capital gains,” and it refers to the difference between the purchase cost of the property (plus any improvements you’ve made) and the sale price.

To avoid tax penalties, you need to understand how the capital gains tax applies to your property sales and different conditions that may exempt you from tax.

As experts with over 32 years of experience in facilitating successful 1031 exchanges, Universal Pacific 1031 Exchange have the required experience to help you understand, file, and report your real estate taxes accurately. We’re always available to help you maximize the tax benefits of the 1031 exchange while staying compliant with IRS rules. Book a free consultation with us today –  let’s discuss your exchanges needs and get started immediately.

Whether you’re a first-time home seller or a seasoned real estate investor, this article will guide you through the basics of capital gains tax to advanced strategies for reducing tax liabilities.

When Do You Pay Capital Gains Tax on Real Estate Sales?

When Do You Pay Capital Gains Tax on Real Estate Sales?

When you owe capital gains tax, you may face severe legal consequences if you do not report or pay the taxes appropriately. So, it’s important to properly understand when you need to pay capital gains tax on your home sale to stay compliant with IRS regulations.

According to Publication 523 of the Internal Revenue Service, you must pay capital gain tax on any profit you make from selling a home if it wasn’t your primary residence. If you live in more than one home, you should conduct a “facts and circumstances” test to confirm which home is your primary residence. The test analyzes factors such as how much time you spend in a home, the address on your official documents (like your driver’s license), how close the home is to your workplace or a relative’s home, etc.

Secondly, you must pay capital gains taxes if you do not meet the ownership requirement. The ownership requirement means you must have owned the home for a minimum of two years within the last 5 years leading up to the date of sale of the home. If you’re filing jointly as a married couple, either you or your spouse can meet this requirement.

Also, you’ll pay capital gains tax if you have not owned the home and used it as your primary residence for at least two years out of the five years leading up to the sale. This is also known as the two-year property rule. These two years do not need to be consecutive. For instance, vacations and other temporary absences don’t count as being “away.”

Regardless of how long you have owned and lived in an investment property, you’ll still pay capital gains tax if you purchased your home through a 1031 exchange, within the past five years. Moreover, if you’ve already claimed capital gains tax exclusion for a previous home sale within two years, it may affect your chances of exclusion on your current home sale. That is, all realized profits from your current sale will be subjected to capital gains taxes.

How to Calculate Capital Gains Tax on a Home Sale

How to Calculate Capital Gains Tax on a Home Sale

Capital gain is the profit you get from the sale of a capital asset, such as stock, bond, or real estate when the selling price exceeds the purchase price. It’s essentially the increase in the value of an asset over the time you own it. Capital gains are usually realized when the asset is sold, but they can also occur when you exchange or convert the asset into a different asset. It’s crucial to understand how it’s calculated to accurately file your tax return.

Capital Gains Tax Rates

The IRS applies capital gains taxes at different rates depending on your total taxable income. Below is a simple breakdown of tax rates for various ranges of taxable income.

A 0% tax rate on capital gains is applicable if your taxable income does not exceed:

  • $44,625 for individuals who are single or married filing separately;
  • $89,250 for those married filing jointly or qualifying widows or widowers;
  • $59,750 for heads of households.

If your taxable income falls within the following ranges, a 15% tax rate on capital gains is applied:

  • Over $44,625 but not over $492,300 for single filers;
  • Over $44,625 but not over $276,900 for married filing separately;
  • Over $89,250 but not over $553,850 for married filing jointly or qualifying surviving spouses;
  • Over $59,750 but not over $523,050 for heads of households.

Income exceeding these brackets for the 15% rate will see capital gains taxed at 20%.

  • Gains from the sale of qualified small business stock under section 1202 are capped at a 28% tax rate.
  • Capital gains from selling collectibles, like artwork or coins, are also taxed at a maximum rate of 28%.
  • Unrecaptured section 1250 gains from the sale of real property under section 1250 are subject to a maximum tax rate of 25%.

Step-by-Step Process for Calculating Capital Gains Tax

Step-by-Step Process for Calculating Capital Gains Tax

Calculating capital gains tax on real estate sales requires that you understand crucial factors such as the adjusted cost basis, holding period, and the applicable tax rates. Below is a breakdown of the calculation process.

  1. Calculate the Adjusted Basis: This is the original purchase price of the property, plus any related expenses incurred during the ownership period. Such expenses may include closing costs, legal fees, and the cost of improvements or renovations that have added value to the property.
  2. Calculate the Capital Gain or Loss: Subtract the adjusted basis from the sale price to calculate the capital gain or loss. If the result is a positive number, it’s a capital gain. If it’s negative, it’s a capital loss.
  3. Identify the Holding Period: Determine how long you owned the property. The holding period is important because it affects the tax rate applied to the capital gain. If you owned it for more than a year before selling it, you’ll pay the long-term capital gains tax rate. But if the holding period is less than a year, you’ll pay the short-term capital gains tax rate, which is typically higher than long-term capital gains rates.
  4. Consider Any Special Tax Provisions: Check if any special tax provisions apply that could affect the capital gains calculation. For example, the primary residence exclusion allows you to exclude up to $250,000 ($500,000 for married couples filing jointly) of gain from your income.
  5. Determine the Applicable Tax Rate: If you have a net capital gain, the tax rate depends on whether it’s a short-term or long-term gain. Short-term gains are taxed at ordinary income tax rates, while long-term gains benefit from lower tax rates (0%, 15%, or 20%, depending on your taxable income).
  6. Calculate the Capital Gains Tax: Apply the appropriate tax rate to your net capital gain to calculate the capital gains tax.
  7. Report the Capital Gain or Loss: Report the capital gain or loss on your tax return using Schedule D (Form 1040). Include any relevant supporting documentation, such as receipts for improvements or renovations.

Example Calculation

Say the initial purchase price of your home was $200,000, and you later sold the home for $300,000 after spending $20,000 on improvements. This is how to calculate the capital gains tax.

  • Sale Price: $300,000
  • Purchase Price (Cost Basis): $200,000
  • Improvement Costs: $20,000
  • Adjusted Cost Basis: $200,000 (Purchase Price) + $20,000 (Improvements) = $220,000
  • Gross Capital Gain: $300,000 (Sale Price) – $220,000 (Adjusted Cost Basis) = $80,000
  • Net Capital Gain: Assume this is the only asset sale; the gross gain is the net gain.
  • Tax Rate: Assuming a long-term gain and a tax rate of 15%.
  • Capital Gains Tax Owed: $80,000 (Net Capital Gain) x 15% = $12,000

Short-term vs. Long-term Capital Gains 

The IRS generally considers capital gains to be either short-term or long-term, depending on how long you’ve held the asset. This distinction can affect your tax bill, as short-term capital gains taxes are usually higher than long-term rates.

Short-term Capital Gains

If you’ve owned a property and sold it within a year or less, any profit from the sale is your short-term capital gain. Short-term capital gains are usually taxed like your ordinary income tax rate. Depending on your income, the rate ranges from 10% to 37% of your capital gains.

Long-term capital Gains

A long-term capital gains tax applies to an investment property owned for more than a year. The tax rates for long-term gains are generally lower, typically 0%, 15%, or 20%, again depending on your income and filing status. Capital gains tax encourages long-term investment, as the tax rate is lower for assets held over a longer period.

Capital Gains Tax Exemptions

Capital Gains Tax Exemptions

In the United States, there are several exemptions and special rules that can reduce or eliminate capital gains tax on certain types of investments or under specific circumstances. These exemptions are stipulated to encourage long-term investment and homeownership. Understanding these exemptions can help in planning and managing your investments more effectively. Some notable capital gains tax exemptions and special rules include:

  1. Principal Residence Exclusion: The Principal Residence Exclusion allows you to exclude up to $250,000 of the taxable gain from your income if you’re single, or up to $500,000 if you’re married filing jointly, provided you meet the ownership and use tests.
  2. Investment in Small Business Stocks: Under Section 1202 of the Internal Revenue Code, investors in qualified small business stocks (QSBS) held for more than five years may exclude 50% of their taxable income gain.
  3. 1031 Exchanges: Also known as a like-kind exchange, this provision allows investors to defer paying capital gains taxes on the sale of real estate if they reinvest all the sale proceeds into a like-kind replacement property. To maximize the tax advantages of a 1031 exchange, you must follow the rules and requirements stipulated by the IRS regarding the timeline, identifying replacement properties, and other important factors. It’s best to consult with an experienced Qualified Intermediary to facilitate the exchange and guide you throughout the process.
  4. Opportunity Zones: Investments in Opportunity Zones, which are economically distressed communities, can qualify for capital gains tax benefits. If you hold an investment in an Opportunity Fund (which invests in Opportunity Zones) for at least 10 years, you may be eligible for capital gains tax exemption from the sale of that investment. Examples of Community Zones in California include Oakland and Cupertino.
  5. Retirement Accounts: Investments in qualified retirement accounts, like IRAs and 401(k)s, are not subject to capital gains tax upon the sale of the investments within the accounts. Instead, the tax treatment depends on the type of retirement account: distributions are taxed as ordinary income for traditional IRAs and 401(k)s, while qualified distributions from Roth IRAs and Roth 401(k)s are tax-free.
  6. Gifts and Inheritances: Capital gains tax does not apply at the time of receiving a gift or inheritance. However, the cost basis and holding period for the real asset may be transferred to the recipient, affecting the calculation of capital gains when the recipient sells the asset. For inherited assets, the basis is generally “stepped up” to the market value at the time of the original owner’s death, potentially reducing the capital gains tax if the asset is sold.

How to Avoid Capital Gains Taxes on Real Estate

How to Avoid Capital Gains Taxes on Real Estate

With the right approach, you can lessen your tax burden and maximize your returns. Here are some tips to consider.

  • Live in the property as your main home for at least two years before selling it.
  • Using the 1031 exchange, reinvest funds from selling one property to buy another like-kind property and defer paying capital gains tax.
  • Transfer ownership to a family member to potentially avoid capital gains tax, but be aware of gift tax rules.
  • You can qualify for Partial Exclusion of Gain if you sell the house due to a change in workplace location, health reasons, or an unexpected event.
  • Keep records of property upgrades and repairs. They could potentially reduce your capital gains tax.

Zoning Laws, Urban Development, and Their Tax Implications

LA’s zoning updates and urban development plans, especially those increasing residential density near transit hubs, are crucial for sellers to consider. These changes can affect property values and, therefore, capital gains tax liabilities. Being informed about how these local policies impact property values can help sellers make more strategic decisions.

The Economic Landscape and Real Estate Investments

The economic conditions in Los Angeles, driven by the tech and entertainment industries, create unique opportunities for real estate investors. Areas like Silicon Beach are seeing property values rise rapidly. For sellers, understanding options such as 1031 exchanges or investing in Opportunity Zones can offer ways to manage capital gains tax more effectively.

Defer Taxes Through a 1031 Exchange

For a successful and compliant real estate investment experience, you must master when and how to calculate, file, and report the appropriate taxes on your real estate transactions. It’s also important to learn the different strategies that can help you maximize tax benefits to minimize the tax burden on your taxable income and make sense in your local market.

If you’re looking to defer capital gains taxes through a 1031 exchange, our experienced qualified intermediaries at Universal Pacific 1031 Exchange can help facilitate a smooth exchange and guide you through the process. Schedule a free consultation with us today to get started.

About The Author

Michael Bergman, CPA
Michael Bergman is a California licensed CPA and Real Estate Broker with over 32 years of experience in commercial real estate. Specializing in 1031 tax-deferred exchanges and financial oversight, his expertise is invaluable for complex real estate transactions. Michael’s unique blend of financial acumen and real estate knowledge positions him as a trusted advisor in the industry, offering sound advice and strategic insights for successful property management and investment.

Don’t let taxes hinder your property investment decisions. Connect with us today for a free, no-obligation 1031 exchange consultation. Let us help you navigate the process with ease.