Knowing the rules for capital gains tax on real estate and home sales is important. Although the residential real estate market has been up and down lately, your property has likely increased in value since you purchased it. Eventually, when you dispose of the property, either voluntarily or involuntarily, you'll need to determine the federal income tax consequences concerning that built-in appreciation.
Perhaps you want to sell your main home, vacation home, or residential rental property that you own. Or you might, unfortunately, be experiencing financial trouble and are considering negotiating a short sale of your home with the bank. Other people may have had their homes destroyed in a wildfire, hurricane, or other natural disaster. You certainly don’t want to be hit with a larger-than-necessary tax bill.
Continue reading to find out how your capital gains may be taxed (or not) in different situations, including a couple of ways to defer a potential capital gains tax hit.
Many people know the basics of the capital gains tax. Gains on the sale of personal or investment property held for more than one year are taxed at favorable capital gains rates of 0%, 15%, or 20%, plus a 3.8% investment tax for people with higher incomes.
Compare this with gains on the sale of personal or investment property held for one year or less, taxed at ordinary income rates up to 37%. But there are lots of exceptions to these general rules, with some major carveouts applying to residential real estate.
Primary Home Sales
Capital gains tax on a primary home
Many homeowners are aware of the general tax rule for home sales. If you have owned and lived in your main home for at least two of the five years leading up to the sale, up to $250,000 ($500,000 for joint filers) of your gain is tax-free. Any gain over the $250,000 or $500,000 exclusion is taxed at capital gains rates. Losses from sales of primary homes are not deductible.
Here's an example:Say you're married, bought your home in 2000, have a tax basis of $325,000, and are selling the home for $650,000. The entire $325,000 gain is tax-free. Let's now take the same example, but instead of selling the home for $650,000, you sell it for $900,000. The first $500,000 of the gain is tax-free, and the remaining $75,000 is taxed at long-term capital gains rates.
To determine your gain or loss from the sale of your primary home, you start with the number of gross proceeds reported in Box 2 of Form 1099-S and subtract selling expenses such as commissions to arrive at the amount realized.
You then reduce that figure by your tax basis in the home to come up with your gain or loss.
To figure your tax basis, start with the original cost, add certain settlement fees and closing costs, plus the cost of any additions as well as improvements that add to the value of your home, prolong its useful life or adapt it to new uses.
IRS Publication 523 has some examples of improvements that increase your tax basis in the home and those that don’t.
If you must sell your home early, you may still be eligible for a portion of the exclusion, depending on the circumstances. Sales due to job changes, illness, or unforeseen circumstances qualify. The percentage of the $500,000 or $250,000 gain exclusion that can be taken is equal to the portion of the two-year period that you used the home as a residence.
For example, say a single person bought a home for $720,000 in March 2022, lived in it for 15 months, and sold it in May 2023, for $785,000 after moving out of state for a job. The maximum gain exclusion in this instance is $156,250 ($250,000 x (15/24)). So, the $65,000 gain is fully excluded and tax-free. You can use days or months for this calculation.
Selling primary home after death of a spouse
A spouse who sells the family home within two years after the death of the other spouse gets the full $500,000 exclusion that is generally available only to couples, provided the two-out-of-five-year use and ownership tests were met before death.
There is also a welcome added tax benefit if you owned the home jointly with your spouse.
If you don’t live in a community property state, half of the home will get a step-up in tax basis upon the death of the first-to-die spouse.
The rule is more generous if the house is held as community property.
The entire tax basis is stepped up to fair market value when the first spouse dies.
Here’s an example.
Let’s say you and your spouse bought a home for $150,000 many years ago in a non-community property state, and it is worth $980,000 on the date the first of you dies. The survivor’s tax basis in the home jumps to $565,000 (his or her half of the original $150,000 basis plus half of the deceased spouse’s $980,000 date-of-death value).
Twenty months later, the surviving spouse sells the home for $1,085,000. Of the $520,000 gain from the home sale ($1,085,000 - $565,000), $500,000 is tax-free and $20,000 is taxed at long-term capital gains rates.
Selling a primary home where you claimed a home office deduction
You may be wondering whether the capital gain tax on the sale of your home would differ if you took the home office tax deduction in prior years for using a room or other space in your residence exclusively and regularly for business or rental (e.g., as a home office or the rental of a spare bedroom). It depends.
Generally, the tax consequences are the same whether or not the home office deduction was previously claimed. Gain on the office or rental portion generally qualifies as part of the $250,000/$500,000 capital gains tax exclusion for the sale of a primary home, subject to two exceptions.
The first is for so-called unrecaptured Section 1250 gain, which applies if you took depreciation deductions in the past for the office or rental space. (This is discussed in more detail below.) If you used the simplified method to claim home office deductions on your return, you don't have to worry about this.
The second exception applies if the workspace or rental space is in a building on the property that is separate from the main home – think first-floor storefront with an attached residence, rented apartment in a duplex, or working farm with a farmhouse on the property.
Rental Property
How are capital gains calculated on rental property?
If you hold rental property, the gain or loss when you sell is generally characterized as a capital gain or loss. If held for more than one year, it's long-term capital gain or loss and if held for one year or less, it's short-term capital gain or loss. The gain or loss is the difference between the amount realized on the sale and your tax basis in the property.
The capital gain will generally be taxed at 0%, 15%, or 20%, plus the 3.8% surtax for people with higher incomes. However, a special rule applies to gain on the sale of rental property for which you took depreciation deductions.
(Image credit: Getty Images)
When depreciable real property held for more than one year is sold at a gain, the rule requires that previously deducted depreciation be recaptured into income and taxed at a top rate of 25%. It's known as unrecaptured Section 1250 gain, the number of its federal tax code section.
Vacation Home
Capital gains on sale of vacation home
Gains from the sale of vacation homes don't qualify for the $250,000/$500,000 capital gains tax exclusion that applies to the sale of main homes.
When you sell a vacation home, your gain will be subject to the normal capital gains tax on real estate.
If you owned the home for more than one year before you sell, then the difference between your amount realized on the sale and your tax basis in the home is subject to a capital gains tax rate of 0%, 15%, or 20%, depending on your income, plus a 3.8% surtax for upper-income individuals.
For example, say you sell a vacation home that you owned since 2010 for $775,000, and you have a tax basis of $610,000. Your $165,000 gain is taxed at capital gains rates. As with primary homes, you can't deduct a loss on the sale of a vacation home.
What if you convert a vacation home to your primary residence, live there for at least two years, and then sell it? Can you qualify for the full $250,000/$500,000 capital gains tax exclusion? The answer is no.
If you sell a main home that you previously used as a vacation home, some or all of the gain is ineligible for the home-sale exclusion.
The portion of the gain that is taxed is based on the ratio of the period after 2008 that the home was used as a second residence or rented out to the total time that the seller owned the house.
The remaining gain is eligible for the $250,000 or $500,000 home-sale exclusion.
Short Sale
Capital gains from a short sale of your main home
Some financially distressed homeowners might be considering a short sale of their home. A short sale occurs when your mortgage lender agrees to accept less than the outstanding balance on your loan to help facilitate a quick sale of the property. The tax rules applicable to short sales differ depending on whether the debt is recourse or nonrecourse.
Recourse debt is when the debtor remains personally liable for any shortfall. If the lender forgives the remaining debt, a special tax rule provides that up to $750,000 in forgiven debt on a primary home is tax-free. The debtor will be taxed on any remaining forgiven debt at ordinary income tax rates up to 37%.
The tax results are different for nonrecourse debt, meaning the debtor isn't personally liable for the deficiency. In this case, the waived debt is included in the amount realized for calculating capital gain or loss on the short sale. For primary homes, no loss is allowed, and up to $250,000 of gain ($500,000 for joint filers) can be excluded from income for homeowners that meet the two-out-of-five-year use and ownership tests.
Other Situations
Destruction of your main home
If your principal residence is damaged or destroyed in a hurricane, widespread wildfire, or other federally declared disaster, you'll have gain to the extent the insurance proceeds you receive exceed your pre-disaster tax basis in the home.
Up to $250,000 ($500,000 for joint filers) of that gain is excluded from income if you meet the two-out-of-five-year use and ownership tests.
Gain in excess of those amounts is taxed at capital gains rates.
One way to delay the tax hit on all or part of the otherwise taxable capital gains is to use the proceeds you get from your insurance company to buy a new home within four years of the disaster. The so-called "involuntary conversion" rules are complex, so be sure to contact your tax adviser if you are thinking about going down this road.
Capital gains tax on 1031 exchanges
When real property used in a business or held for investment is exchanged for like-kind real property under Section 1031 of the tax code, all or part of the gain that would otherwise be triggered if the realty were sold can be deferred. This tax break doesn't apply to main homes or vacation homes, but it can apply to rental real estate that you own.
The 1031 exchange rules are very complicated and tricky, with many requirements to meet. As a result, make sure to talk to your tax adviser if you're contemplating a like-kind swap.
Can you defer capital gains with Opportunity Funds?
The program allows taxpayers to deter capital gains from the sale of business or personal property, including real estate, by investing the proceeds in entities called Qualified Opportunity Funds.
These QOFs then use the money to help the development of struggling communities.
Let’s say you have a large capital gain from the sale of a rental home that you owned, and you want to defer paying federal income tax on that gain. If you can invest those gains proceeds in a QOF, you could see lots of tax benefits.
The gains are deferred until the earlier of Dec. 31, 2026, or when you dispose of your QOF interest. The tax would generally be owed at that time on the deferred gains less the tax basis in the QOF investment.
The longer one holds a QOF investment, the more tax incentives there are. You, as the investor, would begin with a zero-tax basis.
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How long you hold your QOF Investment
What happens to your basis
If you hold your QOF investment for at least 5 years
Your basis in it increases by 10% of the originally deferred gain, meaning that 10% of the deferred gain can go permanently untaxed.
If you hold your QOF investment for at least 7 years,
Your tax basis in it is further increased by 5% of the gain that was originally deferred.
If you hold your QOF investment for 10 years or more
You can then elect to increase your basis to fair market value at the time you sell the investment, so that post-acquisition appreciation in the QOF isn’t taxed when the interest is sold.
(Note that the deferred gain from your real estate sale will be taxed in 2026.)
You have 180 days from selling your real estate to invest the proceeds in a QOF. You can invest all of your short- or long-term capital gain proceeds from the sale or just part of the gains. But if you invest part of the gains, only that portion of the gains contributed to the QOF qualifies for deferral.
If you decide to go the QOF route, you must elect the tax deferral on your tax return for the year of the sale. Follow the instructions on Form 8949 for electing deferral and reporting the deferred gain and submit Form 8949 with your return.
Also, you’ll have to complete and attach Form 8997 to your return. The 8997 lets the IRS know of the QOF investment and the amount of gain deferred, among other information.
Joy is an experienced CPA and tax attorney with an L.L.M. in Taxation from New York University School of Law. After many years working for big law and accounting firms, Joy saw the light and now puts her education, legal experience and in-depth knowledge of federal tax law to use writing for Kiplinger. She writes and edits The Kiplinger Tax Letter and contributes federal tax and retirement stories to kiplinger.com and Kiplinger’s Retirement Report. Her articles have been picked up by the Washington Post and other media outlets. Joy has also appeared as a tax expert in newspapers, on television and on radio discussing federal tax developments.
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