A Guide to Capital Gains Tax on Real Estate Sales

In addition to the rates shown in the table, high-income taxpayers may also have to pay an additional net tax of 3.8% on investment income.

On the other hand, if you held the asset for a year or less before selling it, any net profit will be considered a short-term capital gain, taxable as ordinary income. For example, if you’re in the 22% tax bracket, that’s the rate you’ll pay on short-term gains.

Capital gains tax on a principal residence

If you sell your primary residence, it might qualify for special treatment, even if the sale brought you a six-figure profit. However, it’s not as simple as selling a house you live in. To benefit from the principal residence exclusion, you must meet two conditions:

  • You must have owned the home for at least two of the last five years.
  • You must have lived in the house as your primary residence for at least two of the past five years.

These requirements do not necessarily need to be met in the same two years, but the key thing to remember is that there is an absolute minimum two-year requirement. And you can only use the exclusion once every two years. In other words, if you buy a house and sell it a year later, you cannot use the exclusion, whether or not it was your principal residence when you owned it.

If you qualify, the principal residence exclusion can exempt up to $500,000 of net profit from capital gains tax for married couples filing jointly, or $250,000 for all other taxpayers. So if your cost basis in your home that you jointly own with your spouse is $400,000 and you end up selling it for $900,000, the IRS can’t touch a penny of your earnings.

Additionally, since there is a two-year minimum ownership period used to define a principal residence, any capital gain you owe on such a sale is long-term capital gain.

Cost base 101

Before going any further, it is important to mention the basic concept of cost since it is used to determine your potential tax liability.

In a nutshell, your base cost in a property can consist of three elements:

  • The purchase price of the property.
  • Certain acquisition-related expenses, such as legal fees and transfer taxes.
  • Property improvements that add value to the property or extend its useful life (but not necessary maintenance or repairs).

As a basic example, if you buy a property for a purchase price of $200,000, pay $5,000 in acquisition costs, and spend $20,000 to renovate the kitchen, your base cost will be 225 $000.

Tax on the capital gain of a second home

A second home is generally defined as a property that you live in for part of the year and that is not primarily a rental property. For example, if you have a condo at the beach that you live in for two months each summer and also rent out for a month during the summer season, it likely qualifies as a second home.

Note that you may have more than one property that meets the definition of a “secondary residence”. For example, if you have a condo on the beach and a mountain cabin that you live in at certain times of the year, but also maintain a primary residence, both properties may be considered second homes for purposes. tax.

Since a vacation home does not meet the IRS definition of a principal residence, it does not qualify for the capital gains exclusion. In a nutshell, any net capital gain you realize on the sale of a second home is taxable at the appropriate rate (long-term or short-term). This also applies to a principal residence that you have lived in or owned for less than two years.

Capital gains tax on investment property

When you sell an investment property, you have to worry about two types of taxes.

First, if you sell the property for a net profit over your cost base, you will have to pay capital gains tax.

Additionally, if you have claimed any depreciation expense on the property during your holding period (this is always rental properties), the cumulative amount you deducted will be considered taxable income upon sale. This concept is known as depreciation recapture.

Consider this example. Let’s say your base price in a duplex is $250,000 and you’ve owned it for 10 years. Over the 10-year ownership period, you claimed a total of $90,900 in depreciation expense. If you sell the property now for net proceeds of $350,000, you will owe long-term capital gains tax on your net profit of $100,000 more capital cost allowance recapture on $90,900, which is taxed at your marginal tax rate.

Avoid capital gains tax on investment property

As you can see, selling an investment property – especially one you’ve owned for a long time – can result in a pretty hefty tax bill.

Fortunately, there is a way to avoid paying both capital gains and depreciation recapture taxes, at least for a while. This is called a 1031 exchange, and while there are several important rules and procedures to follow, the basic idea is that as long as you use all proceeds from the sale of your investment property to acquiring another investment property, you can defer taxes until the eventual sale of the replacement property.

When in doubt, ask for help

Finally, it’s important to point out that it’s impossible to cover every potential real estate sale situation in this article, and there is admittedly a gray area in the tax code. For example, you may have done some repairs/upgrades while you were an owner and you are not sure if this should be added to the base cost of ownership.

In such situations, it is important to seek the advice of a qualified professional, such as a tax lawyer or a reputable and experienced tax professional. Ideally, look for one that specializes in real estate matters. High tax issues, such as real estate capital gains have the potential to be, are closely watched by the IRS, so it is not only important to seek advice to ensure you maximize your tax breaks, but to ensure that you are doing it correctly.

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