Every homeowner wants to maximize their profits when they sell their home. It is essential to understand how taxes on capital gains apply when selling real estate.
What are capital gains?
The profits you earn from selling assets such as your house or car – as well as stocks, bonds, and other investments – are capital gains. These amounts are taxed only after the asset is sold.
Taxes are not levied on assets that are actively earning or appreciating while they are held by investors. The only exception applies to mutual funds – investors in mutual funds may be charged for capital gains when shares of the fund’s holdings are sold.
How are capital gains taxed?
Two types of tax rates apply to capital gains levied on real estate sales, depending on how long you have owned and occupied the house:
- Short-term capital gains taxes apply to assets held for less than a year. Short-term gains are taxed at the same rate as your regular income, which makes these rates higher.
To find out what tax bracket your income falls into, click here.
- Long-term capital gains taxes apply to assets owned for longer than 12 months. These are generally lower, capped off at 20% as established by the American Taxpayer Relief Act of 2012. In some cases, you may even qualify for a full exemption, or a 0% tax rate.
How can you avoid or reduce taxes on capital gains when you sell your house?
The Internal Revenue Service (IRS) allows exemptions of up to $250,000 in capital gains for single homeowners. For married homeowners filing jointly for exemption, up to $500,000 is excluded from the taxable amount.
These exclusions apply under the following conditions:
- You owned the house for at least two years within the last five years prior to the sale of the property.
- You occupied the property as your primary residence for at least two years – whether consecutive or non-consecutive – in that same five-year period. (Persons with disabilities, military service members, and members of the Foreign Service or intelligence community are exempt from this rule.)
- You have not claimed any capital gains tax exclusions for another property that was sold two years prior to the current home sale.
Any property owner who is subject to an expatriation tax (individuals who renounce their citizenship) are not allowed to claim any of these exclusions.
A sample computation of a real estate property asset’s capital gains
Determining the total amount of capital gains from a sale involves more than just the difference between the original purchase price and the final selling price. To compute for the actual amount of your capital gains, you need to determine the cost basis of your home purchase. This total comprises:
- The original purchase price
- Taxes and fees paid at the time of purchase (typically between 2% to 5% of the purchase price)
- Additional amounts spent to add value to the property (e.g. upgrades and renovations)
For example, you bought a house 10 years ago for $150,000, paid an additional 3% in taxes and fees (amounting to $4,500), and spent $50,000 on home improvement during your stay. These make the cost basis for your capital gains $204,500.
|Original purchase price||$150,000|
|Closing fees and taxes||+ $4,500|
|Home improvement expenses||+ $50,000|
|TOTAL (Cost basis)||$204,500|
If you were able to sell this house for $700,000 this year, you earned a capital gain of $495,000.
|Final sale price||$700,000|
|Cost basis from purchase||– $204,500|
|PROFIT (Capital gains)||$495,000|
This means if you are married and filing jointly, your household is fully exempted from paying any capital gains taxes. Your total capital gain falls fully within the $500,000 exclusion that the IRS allows.
However, if you are a single homeowner, $245,000 out of your $495,000 capital gain is still subject to tax.
How are investment properties affected by the capital gains tax?
Investment properties are subject to the 1031 Exchange provision, which enables real estate investors to earn a profit without paying any capital gains tax.
Section 1031 of the IRS code allows the exchange of “like-kind” properties. For example, exchanging one retail property for another retail property is allowed, but trading it for a rental property is not.
Ready to dive into the process of selling a house? Get in touch with Windseeker Realty and get top-rated professional guidance from the leading real estate experts in Wisconsin’s Bayfield area. Call us today at 715.779.5000 or email Agent(at)WindseekerRealty(dotted)com to learn more.