There’s a lot of pride associated with owning property, whether it’s a primary home or a vacation bungalow. It’s especially rewarding when real estate is properly compensated for. But while a high-selling price may be exciting in the moment, it typically comes with a potential drawback. As a capital asset, any gains you make on the sale of your real estate are taxable. It’s important to understand how capital gains apply to a home and how you can lower their sting. A financial advisor can help you create a financial plan for your real estate needs and goals.
What Are Capital Gains Taxes?
From personal items to investment products, almost all of your possessions are capital assets. That includes property like cars or real estate and investments like stocks or bonds. Let’s say you decide to sell one of these assets, such as your home. The profit you make from the sale can potentially incur a tax called a capital gains tax.
Long-term capital gains occur when you sell an asset that you’ve held for more than one calendar year. Short-term capital gains occur upon the sale of an asset that’s been held for less than a year. While tax rates vary, long-term capital gains are typically taxed less than short-term capital gains.
When Do You Have to Pay Capital Gains Taxes?
It’s important to note that capital gains taxes only kick in for realized gains. That means it applies once you sell the asset for more than its basis. If a gain is unrealized, meaning you still own the item, then this specific tax does not come into play.
The long-term capital gains tax rate varies between 0%, 15% and 20%. There are a few higher rates for particular items, but they don’t apply to a home sale. In contrast, short-term capital gains are taxed as normal income, which can be a much higher rate. Income tax rates vary between 10% and 37%.
Do You Have to Pay Capital Gains Tax on Real Estate?
Taxes come into play almost any time you make money. So, if you make a profit off the sale of your property, you’ll probably run into capital gains tax. For example, if you purchased a property six years ago for $200,000 and sold it today for $300,000, your profit would be $100,000. You would have to report that sale and possibly pay a capital gains tax on the resulting profit. The exact amount of tax would then depend on your adjusted gross income (AGI), filing status and length of ownership.
But before you can even calculate the taxes you owe, you need to determine your tax basis. The basis is the amount of money you’ve put into the property, otherwise known as your capital investment. For a home sale, the tax basis depends on the circumstances in which you came to own your home. There are three scenarios:
- If you bought your home: Cost basis begins with the purchase price and includes specific closing costs. Remodeling and construction expenses that add to the property value or longevity also contribute to the cost basis. Lastly, if you paid any taxes intended for the seller, those add on as well.
- If you inherited your home: Cost basis begins with the home’s value at the time of the previous owner’s passing. This is what’s known as a step up in basis. That’s because you don’t have to account for gains taxes dating all the way back to the property’s purchase.
- If your home was a gift: Cost basis for a gifted home stays consistent. So, the cost basis for the previous owner remains the basis for the new owner. However, there may be some exceptions. There are also potential gift tax consequences since you must report any gifts over $17,000 in 2023 (up from $16,000 in 2022) to the IRS. This is the annual gift tax exclusion amount, which goes toward the lifetime gift and estate tax exclusion limit. As of 2023, that’s $12.92 million (up from $12.06 million in 2022) for individuals and $25.84 million for couples ($24.12 million in 2022).
One caveat, though, is that the IRS offers a tax exclusion if the property is your primary residence. However, you need to prove you owned and lived at the house for at least two years. The latter does not need to be consecutive.
How to Avoid Capital Gains Taxes When Selling a House
If you want to make a profit from the sale of your house, you will owe capital gains taxes. However, there are some legal methods to minimize those taxes, such as:
- The 2-out-of-5-year rule: You don’t have to live in the house for years consecutively, but cumulatively. That helps you meet the use and ownership tests. As a result, you may qualify for an exclusion up to $250,000 as an individual or $500,000 as a joint filer.
- Qualify for a partial exclusion: According to IRS Publication 523, certain situations may make you eligible for an exclusion of gain. As long as you sold the home because of work, your health or an “unforeseeable event,” you can exclude some of your taxable gains.
- Hold on to home improvement receipts: The cost basis of your property involves more than its purchase price. It includes any improvements you made as well. The higher your cost basis is, the lower your potential exposure to the capital gains tax.
Everyone wants to make a profit when they sell their home. However, there are expenses to account for, including the capital gains tax. A short-term gains tax will likely result in a higher tax rate, though. So, it may be worthwhile to hold on to a property long enough to qualify for the long-term gains tax. But keep in mind that rules vary. Different types of properties may also result in changes to your potential taxes, so make sure you’ve done your research before making a decision.
Tips for Investing
- Navigating the ins and outs of capital gains taxes can be challenging. If you want to understand your tax responsibility while selling your home, seek professional guidance. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- At one point or another, you’ll face capital gains taxes. But that doesn’t mean you can’t find other areas in your life to cut back costs. If you’re an investor looking to minimize expenses, consider checking out online brokerages. They often offer low investment fees, helping you maximize your profit.
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