Definition
Capital Gains Tax is a tax imposed on the profit made from the sale of an asset, including real estate. In real estate, capital gains tax applies when a property is sold for more than its original purchase price, with the gain being subject to taxation by the IRS and state tax agencies.
Explanation
The capital gain is calculated as the difference between the purchase price (adjusted cost basis) and the sale price of the property. If a homeowner lives in the home for at least two of the last five years, they may qualify for an exemption on a portion of the capital gains.
There are two types of capital gains tax:
- Short-Term Capital Gains Tax – Applies if the property is sold within one year of purchase. These gains are taxed at ordinary income tax rates (which can be as high as 37% depending on income).
- Long-Term Capital Gains Tax – Applies if the property is sold after one year of ownership. The tax rate is lower, typically 0%, 15%, or 20%, depending on the seller’s income.
Some homeowners and investors can reduce their capital gains tax liability through 1031 exchanges, home sale exclusions, or cost basis adjustments.
Example
A homeowner buys a property for $300,000 and sells it ten years later for $450,000. Their capital gain is $150,000. However, since they lived in the home for at least two of the last five years, they may qualify for the primary residence exclusion, which allows single filers to exclude up to $250,000 (or $500,000 for married couples) from taxation.