Understanding Capital Gain Taxes When Selling Real Estate

You’ve probably heard the term “capital gains” float around when it comes to selling real estate, by do you know what it really means? More specifically, are you familiar with the taxes that may have to be paid on these gains, and how they can affect how much money you wind up with?

In simple terms, a capital gain is basically the difference between what you paid for a piece of property and how much you sold it for. It’s essentially the profit you’ve made after selling for more than what you paid for the property, minus any adjustments that need to be made, which we’ll touch upon a little later.

Making a profit on the sale of real estate is fantastic, but unfortunately, you owe taxes on any gains – or profits – that you make when you sell a property in certain circumstances. Typically, these tax obligations come with the sale of a property that is considered an investment.

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When Do Capital Gain Taxes Apply?

Not every gain made on the sale of a home will necessarily be subject to capital gain taxes. The following criteria need to be met in order to be sheltered from capital gain taxes on the sale of a home:

The home is your principal residence. That means you must actually be living in it for this consideration to apply. Tax exemption doesn’t apply for other properties you might own that you don’t live in. How long you lived in the home matters too. In order to be exempt from appeal gain taxes, you must have lived in the home for at least two out of the last five years.

Another home hasn’t been sold or exchanged during the two years following the sale. But that doesn’t mean that you can’t continue to buy and sell in order to avoid capital gain taxes. You can sell your home this year, pocket any gains, and buy and sell another home while still being exempt from taxation, just as long as the sales are spaced at least two years apart. You can basically repeat the cycle over and over, every two years.

You experience what the IRS views as an “unforeseen circumstance.” This can include job loss, a divorce, or a family medical emergency.

What About Second Homes?

If you own more than one home, you’ll quickly find out that any profits you make on a property sale won’t necessarily be sheltered from tax.

A provision of the Housing Assistance Act of 2008 will likely cost owners of vacation homes or other types of second homes when they sell. Prior to this provision, you’d be able to move into the second home, make it your main residence, live there for the necessary two years before selling, then sell it and keep the profits.

Such is no longer the case, even if you convert a second property to your primary residence. Whatever profits you make on the sale of the second property will be subject to tax on a portion of the sale money based on the amount of time that the property was used as a second home, instead of your main residence.

Capital Gain Taxes For Single Sellers Versus Married Couples

As long as the above-mentioned criteria are met, up to $250,000 in capital gains is exempt for single people, or $500,000 for married couples. But while spouses might be able to benefit from double the exclusion compared to single sellers, married couples also need to meet additional criteria before their sale is considered tax-free.

Both spouses must have lived in the home for at least two years, although the shared use doesn’t necessarily need to be while you file for taxes jointly. Both spouses can live with each other for one year before getting married, for instance, and then one additional year after tying the knot. In this case, the IRS will permit a tax exemption for capital gains. However, if one of the spouses doesn’t move in until the actual day that the wedding takes place, tax exemption won’t be granted.

One of the spouses doesn’t have to be on title for the entire two years, as long as one of the spouses has owned the property for at least that long. Meeting the two-year ownership requirement is still possible in this situation when jointly filing taxes as a married couple.

However, one of the spouses must not have sold a previous property within the two-year period. If so, the tax exemption won’t apply. That means if one spouse sold his or her property shortly before getting married, two years will have to pass following the sale of the home before being exempt from capital gain taxes.

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How Are Capital Gain Taxes Calculated?

Before we get into the calculations, it should be noted that the actual sale price has nothing to do with whether or not capital gain taxes are applicable, and how much would need to be paid. Instead, it’s all about the profits. Your home can sell for over $1 million and you still wouldn’t be responsible for paying taxes, as long as your profits are less than $250,000 or $500,000, depending on your marital status at the time of tax filing, and as long as the previously-mentioned criteria are met.

To find out how much gains you made upon the sale of a property, the “basis” in the home needs to be established first. The calculations aren’t as simple as price paid minus price sold for. In order to get a true capital gain amount, you have to factor in an adjusted cost.

Such adjustments will give you a basis for capital gain tax calculations, and include the following:

  • Cost of the purchase (including lawyer fees, inspections, and appraisals);
  • Cost of the sale (including lawyer fees, inspections, and agent commissions);
  • Cost of improvements (including any money spent to add a deck, a room addition, and so on. This does not include any repairs or replacements on existing components).

The basis amount is then compared to how much money you get from the sale, minus commissions and other costs. You’ll get the amount of gain on the property’s sale after subtracting your cost basis in the home.

Improvements will increase your basis amount, so even a small part of the sale price would be considered a gain. Any overage is taxed at respective long-term capital gains rates, which is 15% for most average earners, 20% for higher-income sellers, and even 0% in some cases.

It’s important to understand capital gains, and the taxes you might be responsible for paying after you sell a property. The more you know, the less you’ll be unpleasantly surprised once it comes time to pay Uncle Sam.