How To Avoid Capital Gains Tax On Real Estate (2024)

Even if you're not sure about the definition of capital gains tax, you might automatically think, "Uh-oh, bad news." After all, when does the word "tax" invoke warm, fuzzy feelings?

The good news: Capital gains on a home sale might not affect you at all. Let's take a closer look at capital gains tax on real estate, how it works and how to avoid capital gains tax on a home sale altogether.

Find out more about capital gains tax and how it could affect your tax obligations.

What Is The Capital Gains Tax?

When you sell an asset that increases in value, you may have to pay money on the profit from that investment – this is the capital gains tax. In other words, it's what you pay for the appreciation from your investment. The amount you pay in capital gains taxes depends on your income, tax filing status and how long you owned the asset.

What Types Of Assets Are Subject To The Capital Gains Tax?

Any asset that appreciates is subject to capital gains taxes – including real estate. In this article, we’ll solely focus on capital gains taxes that apply to real estate and the special rules that provide an exemption on the sale of a primary residence.

How Do Capital Gains Taxes On Real Estate Work?

Let's walk through how capital gains on real estate work. Note that you'll want to know the rules so you're familiar with what will happen if you decide to sell your home.

Long-Term Vs. Short-Term Capital Gains

Capital gains and losses are handled according to the holding period, or how long you've held them. You pay short-term capital gains on profits you make from selling assets you’ve held for a year or less. On the other hand, you'll pay long-term capital gains from assets you’ve held for longer than a year.

You'll face different rules and tax rates depending on whether you make short- or long-term capital gains. You usually pay less in taxes on long-term capital gains compared to short-term capital gains.

Let's use this example in a real estate context. Say you own a property for 6 months. If you sell it for a profit after that time, it's considered a short-term gain. You'll get taxed at your marginal tax rate (tax bracket). However, after a year, think of any profit as a long-term capital gain.

Ordinary Income Vs. Capital Gains Taxes

Both ordinary income tax and capital gains taxes are fees you must pay, but think of capital gains taxes as a more favorable tax treatment. In a sense, the federal government "encourages" you to use capital gains over ordinary income tax.

Ordinary income refers to money you make flipping houses or as part of your regular income – through ways in which you work to make money. Short-term capital gains are also taxed at your regular tax bracket, or your ordinary tax rate.

Short-term capital gains are taxed as ordinary income at rates up to 37%; long-term gains are taxed at up to 20%. Again, you'll experience more favorable tax treatment through capital gains taxes.

Capital Gains Tax Rates

Let's look at the exact capital gains tax rates for long-term capital gains (there are multiple tax rates1) and where the income cut-offs are. If your taxable income is:

• Less than $80,000: Some or all net capital gain may be taxed at 0%
• $80,000 or more but less than $441,540 for single filers: 15% capital gain rate applies
• $496,600 for married filing jointly or qualifying widow(er): 15% capital gain rate applies
• $469,050 for head of household: 15% capital gain rate applies
• $248,300 for married filing separately: 15% capital gain rate applies

A net capital gain tax rate of 20% applies to the extent that your taxable income exceeds the thresholds set for the 15% capital gain rate.

Cost Basis

The cost basis in real estate serves as the original value that a buyer pays for a property. You want to note the cost basis because it helps you figure out capital gains or losses on the sale of your property.

Here's the simple math problem you can use:

The Purchase Price (including any closing costs) + Capital Improvements = Cost Basis

You may need to pay capital gains tax on any profit you generate above and beyond what you initially paid for your property, and the cost basis determines what you'll have to pay in tax when you sell your property.

1 https://www.irs.gov/taxtopics/tc409

How To Avoid Capital Gains Taxes On A Home Sale

Now, as alluded to before, it's completely possible to avoid capital gains taxes on a home sale. Here's how it happens.

Capital Gains Tax On Your Home

All U.S. taxpayers are entitled to a personal exemption2 of $250,000 for single individuals and $500,000 for married couples filing jointly. This means you don't have to pay capital gains taxes if you make less than $250,000 on the sale of your house as a single individual or $500,000 on the sale of the home with your spouse.

In addition to the personal exemption rules, you must also meet these other exemption requirements. You:

• Must call the home your primary residence. In other words, it must be your main home and you must live there most of the year.
• Must have used the home for 2 out of the last 5 years versus 1 year for long-term capital gains treatment.
• Can meet the ownership and use tests during different 2-year periods. However, you must meet both tests during the 5-year period ending on the date of the sale.

Let's say Jennifer bought a house 6 years ago. She lived in it full-time during those 6 years. She sells her home and makes $100,000 in the process. She does not need to pay capital gains taxes on her home because she's a single individual and has made less than $250,000 on the sale of her home.

Capital Gains Taxes On Your Second Home

You cannot get a tax exemption for vacation homes. However, many homeowners sell their primary residences first and then make their second home their primary residence.

We'll walk through an example. Mr. and Mrs. Smith have lived in the same home for 20 years and have a vacation home where they spend time during summers and holidays. They sell their primary residence and move into their vacation home, making their second home their primary residence. They make $200,000 on the sale of their primary residence and would qualify for the capital gains exemption.

Next let’s say they make their second home their primary residence and live there for 3 years before deciding to sell. When they sell, they make another $100,000. Since it’s now their primary residence, they’re still below the limit for a married couple, and they wouldn’t have to pay capital gains tax.

Capital Gains Taxes On The Home You Inherited

You may wonder if you need to pay capital gains taxes on a home you inherited. After all, a tax on capital gains, based on the asset’s original value, can often lead to larger expenses.

If you inherit a home, you enjoy a step-up in basis, which means that your cost basis in the home is equal to the fair market value of the home when your benefactor died, not the original purchase price plus capital improvements.

This is really important because it means that you can minimize capital gains taxes when you sell the home. Here's how this can benefit you:

Let's say your benefactor originally bought a home for $45,000. Fifty years later, your benefactor dies and bequeaths you the home, which is worth $1 million. You and your spouse sell the home for $1.4 million 8 years later. You won’t have to pay capital gains tax on the full value of them, just the $400,000 increase in value since it was assessed in the inheritance.

Capital Gains Taxes And Your Investment Property

Capital gains taxes are more complicated when dealing with an investment property. You may want to discuss your situation with a tax or financial professional.

1031 Exchanges

A 1031 exchange allows you to sell an investment or business property and buy another without paying capital gains taxes. The exchange must meet IRS rules and be a like-kind property, which means a property of the same nature. In other words, you trade one real estate investment for another.

However, it's important to note that you defer capital gains taxes – you don't get out of them completely. If there are capital gains when you sell your real estate investment, and you’re not doing another 1031 exchange, you will have to pay capital gains tax.

Opportunity Zones

Opportunity zones, or areas that exhibit significant economic distress, will yield tax savings for those with large capital gains.

• Temporary tax deferral: You can temporarily defer capital gains and gains on the sale of business property. Gains must be reinvested within 180 days of the day they are recognized as taxable income.
• Step-up in basis: The longer you hold onto a property, the more you can increase the basis under which the fair market value of your property is calculated for tax purposes. You get a 10% step-up in basis if you hold an investment for at least 5 years. At 7 years, it increases to 15%.
• Permanent exclusion from taxable income: Holding onto a property for 10 years or more means any appreciation on the investment is excluded from taxable income. Only the amount of your initial investment is taxable.

2 https://www.irs.gov/taxtopics/tc701

What If I Can’t Avoid A Capital Gain This Year?

You can use capital losses to offset capital gains during a taxable year. This can work especially well if you can't avoid capital gains during a given year. This also allows you to remove some income from your tax return. You can also use a capital loss to offset ordinary income.

What IRS Forms Do I Need To File?

Take a look at Form 8949, Sales and Other Dispositions of Capital Assets,3 and then reported on Schedule D (Form 1040), Capital Gains and Losses,4 for the forms you need to file. Talk to your accountant or tax advisor for help in filing if necessary.

3 https://www.irs.gov/pub/irs-pdf/f8949.pdf

4 https://www.irs.gov/forms-pubs/about-schedule-d-form-1040

The Bottom Line: With A Bit Of Planning, Sometimes Capital Gains Taxes Can Be Avoided

For years, the prospect of paying taxes on capital gains for property transactions had been a hindrance to those involved in real estate investment. When you sell a home for more than you bought it for, you may be subject to capital gains taxes on the profit.

However, you can minimize capital gains taxes on sale of a home with some careful tax planning. In fact, many people avoid capital gains on house sales altogether. If you need some help from an expert, speak with a tax professional.

Are you looking to sell your home? Learn more about getting a home ready to sell.