Closing on your home sale is an exciting milestone, but the profits might not be as high as you think. Your mortgage lender, real estate agent, title company, and local government will all take their slice of the pie before you are given a check at the closing appointment. Even after you sell your house, you might have to pay capital gains tax.
What is capital gains tax on real estate and who has to pay it? Learn more about federal taxes on property sales and some potential exemptions you can take advantage of.
What is the capital gains tax?
The capital gains tax isn’t limited to real estate sales. It can be applied to any major investment that you sell. This is a way for the government to tax major assets that you decide to sell for a profit. It also applies to the sale of investments like stocks.
The first thing to note is that you aren’t taxed on the entire sale price of the asset. A capital gain is the sale price minus the original cost of the asset. If you bought a boat for $1,000 and sold it for $10,000, your capital gains would be $9,000.
This is important when calculating capital gains on real estate. You aren’t basing your tax bill on your entire home sale price, just on the profits you walk away with.
Who pays capital gains tax on real estate?
The majority of homeowners will not have to pay capital gains tax on their properties or they will receive a steep discount on what is actually taxed. A lot of this has to do with the Taxpayer Relief Act of 1997. This was one of the largest tax-reduction bills passed in the United States and covered costs related to education savings, child tax credits, and IRAs.
In regard to capital gains, the Taxpayer Relief Act of 1997 lowered the overall tax rate that sellers had to pay from 28% to 20% in the higher bracket and 15% to 10% in the lower bracket. This law also introduced exemptions for sellers. If you are selling your house in 2023, here are a few ways you will be exempt from paying federal capital gains tax on real estate:
- Your profits on the home sale are less than $250,000 for single taxpayers and $500,000 for couples who file their taxes together.
- You lived in the house as your primary residence for two years.
- You earn less than $44,625 as a single taxpayer or $89,250 for married couples who file jointly.
These taxable income thresholds change every year, so make sure you check the income limits and tax filing status when you decide to sell your home.
How do you calculate your capital gains tax bill?
If you are worried that you owe capital gains tax on your home, you can crunch a few basic numbers to estimate what you will owe. Your Realtor, CPA, or real estate attorney should also be able to help you calculate your capital gain.
First, look at your profits. Let’s say you bought a house for $200,000 and sold it for $500,000. Your capital gain on the property would be $300,000. If you are a single filer who lived in the house for at least two years, you might qualify for the $250,000 exemption. This means your taxable profits are $50,000.
Next, look at your taxable income. The IRS publishes updated income numbers for different tax brackets each year. Here are the thresholds for 2023:
If you earn less than $44,625 annually then your tax rate would be 0%. However, if you exceed that limit but earn less than $492,300 annually, your tax rate would be 15%. This means your tax bill for the $50,000 in home sale profits would be $7,400. If your taxable income is more than $492,300 annually, your bill rate would be 20% or $10,000.
Are there deductions for capital gains taxes?
There is good news for homeowners who are worried about their capital gains tax bill: you can deduct some of your home sale expenses in order to report a more accurate number to the IRS for what you gained in profits. This means you can deduct almost any fee or expense that doesn’t affect your physical property from the overall sale price of the home.
What does this mean in layman’s terms? Your closing fees (including your Realtor commission) are deductible from your total gains. Other costs, like advertising expenses, appraisal fees, and attorney fees are also tax deductible.
Using the example from above, you sell your house for $500,000 and have to pay a total of seven percent of the home’s value in closing costs. This includes six percent in Realtor commissions and one percent in other fees. At closing, $35,000 is deducted from your profits and you receive a check for $465,000. This changes your capital gains significantly.
With this new math, your net capital gains on a house you paid $200,000 for is only $265,000. After the $250,000 tax exemption, you only need to pay taxes on $15,000. At a 15% tax rate, you only owe $2,250 – a significant drop from the original estimation of $7,400.
It is always worth looking into deductions before you start calculating your tax bill. Even small fees related to the home sale can have an impact on the taxes you owe.
When do you pay capital gains tax on real estate?
Capital gains taxes are due after the sale of the item. You will need to report the home sale on your taxes when you file them in the spring. For example, if you sell a house in March 2023, you would report the profits when you file in 2024.
Capital gains are reported on Form 1099-S, which is used to report proceeds from the sale or exchange of real estate. You do not fill out this form. Your real estate agency, mortgage lender, or title company will mail you a completed 1099-S by February 15 when you are filing your taxes. You will then include this document in your tax reporting and complete the e-file process by March 31.
If you are worried that you will not receive a completed 1099-S form, contact your Realtor or lender in early January. They can confirm whether you need this form and when it will be sent to you.
Do you have to pay taxes on the capital gain of a vacation home?
If you decide to sell your second home, you will need to pay capital gains tax on the property. This is not your primary residence and you have not lived there for at least two of the past five years. It is also not an investment property. This means you and your significant other do not qualify for the $250,000 to $500,00 tax deduction.
If you really do not want to pay taxes on the sale of that home, you have options. You can move into the property and prove to the IRS that you live there as your primary residence. You may need to delay the home sale for a few years while you live there. To show that it is your primary residence, the IRS would expect to see documentation like a driver’s license, voter registration card, tax documents, or other official forms proving that you live at that address.
Before you move into your lake house full-time, review the IRS requirements for a primary residence to make sure you will qualify for the exemption when it’s time to sell.
Do you have to pay a tax on an investment property?
Not all second homes are taxable under capital gains laws. If you rent out your second house as an investment property, you might be able to avoid capital gains tax bills as long as you set up a 1031 exchange.
A 1031 exchange, called a “Like-Kind Exchange” doesn’t eliminate capital gains taxes, but rather defers them. It is used when you decide to sell a rental property and buy another one for the same reason.
For example, you own a single-family investment property in town that a developer wants to buy to build multi-family housing on the lot. You agree to the deal and use the money to buy another rental property. This would qualify for a 1031 exchange.
There are rules that come with this deferral. The profits from the sale of the first rental property need to be held in a third-party escrow account until you buy the next house. You can never possess that money. The second rental property needs to be like-kind (similar) according to IRS guidelines.
There is no limit to how often you can set up a 1031 exchange. You will eventually pay capital gains taxes when you sell your investment property and accept the cash, rather than using the money to buy another home.
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