What is Capital Gains Tax?

The income tax you pay on gains from the sale of capital assets, such as real estate, is known as capital gains tax. So, if you sell your home for more than you bought it for, you will almost certainly have a capital gain and thus be required to pay capital gains tax on your capital gain. Gains from the sale of your home are taxed in the same way as income and sales taxes. Due to the Tax Cuts and Jobs Act, which went into effect in 2018, the rules have changed slightly.

Who Pays Capital Gains Tax?

Capital gains tax is levied on all belongings and property that you sell for a profit, such as your house. You have a short-term capital gain if you sell your house in one year or less, and you have a long-term capital gain if you sell your house after owning it for more than a year. Long-term gains, unlike short-term gains, are subject to lower capital gains tax rates.

The Primary Residence Tax Exemption

Home sale profits, unlike other investments, may be eligible for capital gains exemptions provided certain requirements are met. These requirements include that 1) you must live in the house as your primary residence, and 2) you must have owned it for at least 1 year.

The IRS provides a $250,000 tax-free exemption on capital gains from a primary residence to everyone regardless of their income. This capital gain can be permanently deducted from your income. For example, if you are your spouse buy a home for $100,000 and sell it for up to $600,000 years later, you won’t incur any capital gains tax.

What’s my capital gains tax rate?

Long-term capital gains tax rates are determined by your income. Prior to 2018, they were determined by tax brackets. For example, if your annual income is less than $40,400 in 2021, you can take advantage of the 0% capital gains tax. The 15% capital gains rate, which applies to incomes between $40,401 and $445,850, will apply to the majority of single people. Long-term capital gains will be taxed at a rate of 20% for single filers with incomes above $445,851.

The brackets for married couples filing jointly are a little higher, but most will be hit with the marriage penalty. The good news is that married couples with earnings of $80,800 or less are still in the 0% tax bracket. Married couples earning between $80,801 and $501,601 will pay a capital gains tax of 15%. Those with incomes exceeding $501,601 will be subject to a 20% long-term capital gains tax.

• Your tax rate is 0% on long-term capital gains if you’re a single filer earning less than $40,400, married filing jointly earning less than $80,800, or head of household earning less than $54,100.
• Your tax rate is 15% on long-term capital gains if you’re a single filer earning between $40,401 and $445,850, married filing jointly earning between $80,801 and $501,600, or head of household earning between $54,101 and $473,750.
• Your tax rate is 20% on long-term capital gains if you’re a single filer earning more than $445,851, married filing jointly earning more than $501,601, or head of household earning more than $473,751. For those earning above $501,601, the rate tops out at 20%.

A short-term gain is if you only kept the property for a year or less. Short term capital gains are taxed at ordinary income rates. That’s the same tax rate you’d pay on other types of regular income, like wages.

Do renovations reduce capital gains?

You can deduct the cost of home modifications from the amount of capital gains payable to capital gains tax. You can calculate your adjusted cost basis by adding the amount you spent on any home renovations (i.e. fixing the roof, installing a deck, changing the floor) to the initial purchase of your property. The lesser your capital gain when you sell your house, the greater your adjusted cost basis is.

For example, if you bought your home for $500,000 and sold it for $800,000, but you invested $100,000 on home upgrades over the years. That $50,000 would be deducted from your home’s sale price, so instead of paying capital gains taxes on the $300,000 profit from the sale, you’d only have to pay taxes on the $250,000 profit. You’d meet the criteria for capital gains tax exclusion in that situation and you’d owe no taxes.

Remember to save receipts for any modifications you make to your house since they can assist with decreasing your taxed income when you decide to sell your house. Keep in mind, though, that these must be house renovations. Ordinary repairs and maintenance on your home are not deductible from your income.

Capital Gains on Inherited Homes

If you are selling a family home that you inherited, the IRS provides a “free step-up in basis.” This means that you pay capital gains tax on only the difference between what you sell the house for and what it was worth when your last parent passed away. For example, your parents paid $100,000 for the family home years ago and it’s now worth $1 million when you inherit it. When you sell, the purchase price when you sell it, or “basis”, is the $1 million it is worth on the last parent’s death date and not the $100,000 that your parents paid.

What If My Home Sells at a Loss?

You can’t deduct a capital loss if you sell your primary house for less than what you bought it for. A capital loss from the sale of your home is considered a personal loss, and it does not lower your taxable income.

However, if you sell other real estate as a loss, you can deduct the loss on your tax return. You may be limited in the amount of loss you can use to offset other taxable income in a given year.

How Investors Avoid Capital Gain Tax

Avoiding capital gains tax can be a little more tricky if the home you’re selling isn’t your primary residence but rather an investment property you’ve flipped or rented out. However, it is still feasible. If you’re an investor, the best approach to avoid capital gains tax is to use a 1031 exchange to transfer “like-kind” properties. This permits you to sell your home and buy another without having to pay any capital gains taxes in the year of the sale.

It is important to note however that there are very rigorous timelines and requirements with a 1031 exchange, so consult an accountant before proceeding. You will face capital gains on the profit if you opt out of the rental property investment business and invest your money in something that doesn’t qualify for a 1031 exchange.

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