Understanding Capital Gains Tax on Real Estate and Property Sales

By Bill Lyons | Updated on August 19, 2024

When you sell your property, you’ll be subject to various tax implications. A capital gain is the rise in value of an asset compared to its original purchase price. When the asset is sold, the profit earned from that sale is subject to capital gains taxes.

Homes are significant investments, so understanding what happens after the sale is crucial since it can affect your finances. Real estate capital gains tax can influence decisions about when and how to sell your property, how much profit you can expect, and strategies to minimize tax burdens.

Keep reading to learn more about capital gains tax on real estate, including how it affects you when selling your home or investment property.

What Is a Capital Gains Tax?

A capital gains tax is a type of tax on the profit obtained when an asset, such as real estate property, has increased in value and is sold. This tax is only triggered upon the sale of the property, so the gain isn’t taxed as it accumulates, only after it’s realized.

Capital gains tax on real estate provides governments with a source of revenue in the same way income tax does. This revenue often goes towards public services and infrastructure. By taxing the profits from asset sales, governments can influence investment strategies and economic behaviors. For instance, it can deter short-term trading in favor of long-term holding, especially since tax rates differ based on how long the asset is held.

Real estate capital gains tax is calculated based on the difference between the selling and original purchase prices, adjusted for additional costs like improvements. The difference is multiplied by the tax rate to determine the amount owed to the government.

An example of a long-term capital gain would be if someone purchased land for $100,000 and sold it five years later for $150,000. The capital gain here is $50,000 ($150,000 – $100,000). If your long-term capital gains rate is 15%, you’d owe $7,500 in taxes ($50,000 x 0.15).

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What Is the Difference Between Short and Long-Term Capital Gains Tax?

There are two types of capital gains: Short-term and long-term capital gains.

Short-term capital gains arise from selling an asset held for one year or less. These gains are taxed as ordinary income.

On the other hand, long-term capital gains on assets held for longer than one year often benefit from lower tax rates than short-term gains to incentivize longer-term investments.

The differences between these two include:

• Holding period: Short-term capital gains are from real estate assets held for one year or less. In contrast, long-term capital gains are from assets held for more than one year.
• Tax rates: Short-term capital gains tax rates on real estate are the same as an individual’s standard income tax rate. In contrast, long-term capital gains benefit from preferential tax rates that are generally lower than typical income tax rates.
• Impact on investment strategy: Because they have higher tax rates, short-term gains can discourage frequent trading since the profit from the sale is significantly reduced after taxes. However, the preferential tax rates of long-term capital gains incentivize investors to hold onto their investments for more extended periods, promoting stability in the market.
• Tax planning: With assets held for less than one year, there are fewer opportunities for tax planning or leveraging strategies to offset gains. However, with long-term investments, investors have more flexibility to plan the timing of their sales to maximize tax benefits.

When Are You Required to Pay Capital Gains Tax?

Investors must pay capital gains tax after selling an asset such as real estate. However, there are specific criteria and exemptions related to homes.

Here’s when you can expect to pay this tax:

• Primary residence exclusion: In the U.S., the sale of your primary residence might qualify for an exclusion, meaning you can exclude a portion of the profit from capital gains tax. To qualify, homeowners need to have lived in the house for a certain period before selling.
• Second homes and investment properties: If you sell a second home, vacation home, or investment property, you’ll usually owe capital gains tax on any profit since these sales don’t qualify for the primary residence exclusion.
• Inherited homes: If you sell an inherited home, you might owe capital gains tax. However, the gain is determined based on the home’s fair market value at the time of the original owner’s death, not what they paid for it, which can significantly reduce the taxable gain.
• Homes used for business or rental: If you’ve used part of your home for business or rented it out, you may owe capital gains tax on that portion of the property when you sell.

How Much Is Capital Gains Tax on Real Estate?

The total capital gains tax burden on real estate largely depends on the type of capital gain. Remember, short-term capital gains are taxed as income, so your income tax rate will be your tax rate for these gains.

On the other hand, long-term gains typically benefit from lower tax rates. To calculate your capital gain, you’ll need to find the difference between the selling price and the property’s original purchase price. Then, deduct all allowable expenses related to the purchase and sale, such as closing costs, agent commissions, and improvements that added to its value. The final number is your capital gain.

Then, you’ll apply the appropriate tax rate based on the type of capital gain it is and the various tax rates. Long-term capital gains tax rates are 0%, 15%, and 20%, depending on income and filing status.

How to Maximize Profits & Minimize Capital Gains Tax

Maximizing profits from property sales while minimizing the associated capital gains tax requires strategic planning and knowledge of tax regulations. To help you make more from your investment and learn how to sell your house to boost returns, here are a few tips:

Rental property sales

One of the key steps when evaluating or selling an investment property is to calculate ROI on rental properties to determine the profitability and effectiveness of your investment strategies. The best way to maximize profits on the sale of a rental property is by enhancing its value. Consider renovating areas like the kitchen and bathroom, which offer the best ROIs. The timing of the sale is also crucial. Selling during a strong market phase or peak season can increase the selling price.

Individuals selling investment properties can reduce their capital gains tax on the sale of a house using the 1031 exchange, which allows them to defer capital gains tax. You can push back your tax obligation by reinvesting the sale into a smaller property.

You may also choose to live in the house. By converting the rental property into your primary residence and living in it for at least two years, you may qualify for the primary residence exclusion when you sell.

Another consideration is depreciation. While you’ll recapture depreciation when selling, you can claim it annually during ownership to offset taxable income. For a more favorable tax rate, hold onto the investment property for over a year to ensure your gains are classified as long-term.

Home sales

To enhance the profitability of your home’s sale, you should consider investing in real estate renovations that can boost the property’s market value. Like with rental properties, the timing of the sale can also affect how much you earn versus how much you pay in taxes.

Regarding capital gains on primary residences, understanding certain provisions can minimize your tax burden. Consider residing in your property for at least two years before the sale. Additionally, some states offer specific tax breaks or advantages related to home sales.

Ensure a Profitable Real Estate Investment

Understanding taxes on real estate investments can help you maximize your returns. From leveraging benefits like the 1031 exchange to strategically timing sales and documenting improvements, every decision plays a crucial role in determining profitability.

To further ensure your success, partner with Griffin Funding. We can guide you through the process of securing a home or investment property loan by helping you find the right mortgage based on your unique financial situation. Apply for a mortgage online today.

Bill Lyons

Bill Lyons is the Founder, CEO & President of Griffin Funding. Founded in 2013, Griffin Funding is a national boutique mortgage lender focusing on delivering 5-star service to its clients. Mr. Lyons has 22 years of experience in the mortgage business. Lyons is seen as an industry leader and expert in real estate finance. Lyons has been featured in Forbes, Inc., Wall Street Journal, HousingWire, and more. As a member of the Mortgage Bankers Association, Lyons is able to keep up with important changes in the industry to deliver the most value to Griffin's clients. Under Lyons' leadership, Griffin Funding has made the Inc. 5000 fastest-growing companies list five times in its 10 years in business.