Do I Have To Pay Real Estate Capital Gains?
If you are about to sell your primary residence, you need to know what the real estate capital gains are to determine how much cash you will actually walk away with, if any, after the sale of your home. Thanks to the Taxpayer Relief Act of 1997, the process has been simplified to help homeowners by utilizing a per-sale exclusion formula instead of the older once-in-a-lifetime provision. Even if you took the earlier provision, you may now qualify to take the new exclusion.
In simple terms, real estate capital gains are the difference between the price you paid for your property and the price you sell it for. The capital gains tax is based on that difference (minus deductions and tax breaks). This is a stand-alone tax that can be different than your income tax rate. It is also important to keep in mind, depending on the state you live in, you may have to pay state tax in addition to federal capital gains taxes.
The Taxpayer Relief Act of 2012 made some adjustments in the form of a $5 million estate tax exclusion as well as raising the maximum estate tax rate to 40%, although neither of these recent provisions will affect most sellers. As always, check with a tax attorney before making any assumptions on capital gains taxes.
To help homeowners calculate their net profit (if applicable), let us examine how homeowner tax benefits and real estate capital gains actually work.
Tax Benefits for Primary Residence Owners
The home you live in is your primary residence, and if you own that home, you get the annual tax benefits of being able to deduct your mortgage interest and property taxes. You also get a large exemption on capital gains taxes when selling your primary residence, assuming you qualify for the tax break.
This exemption applies as long as you have lived in the home for 2 of the last 5 years at the time of sale. Single people are exempt from paying capital gains taxes on up to $250,000 in capital gains, and married couples are exempt from capital gains taxes on up to $500,000.
How to Calculate Capital Gains and Net Profit on a Home Sale
Here is a simplified formula for estimating capital gains taxes and net profit on a sale of your primary residence. Always consult a tax advisor to do these calculations for your exact profile.
Step 1: Calculate your capital gains.
You do this by subtracting the total selling cost (including real estate agent commission, title and local tax fees), cost of improvements you made, purchase price, purchase expenses and any eligible capital gains exemption from the sales price. Then add back any depreciation you took while you owned the home.
The resulting number is your capital gain, and you will pay federal and state taxes of about 25 to 30 percent (based on your tax profile) on the capital gains.
- For homeowners in the 10% to 15% tax bracket, your capital gains tax rate is zero.
- For homeowners in the 25% to 35% tax bracket, your capital gains tax rate is 15%.
- For homeowners in the 39.6% tax bracket, your capital gains tax rate is 20%.
Let us see what this formula looks like with the following assumptions:
- You bought a home 8 years ago for $200,000 with 20 percent down and a 30-year fixed rate of 6 percent, and paid $4,500 in closing costs.
- After imputing the info in a mortgage calculator, your balance is now $140,435.
- You made $10,000 in improvements to the home while you lived there. (Note: improvements are things like kitchen remodels and room additions. The IRS does not count maintenance like roof replacement and painting as improvements.)
- You have lived in the home 2 of the last 5 years.
- You did not take any depreciation along the way.
- You are single.
- You are now selling the home for $505,000.*
- Your county has a total of 7 percent for the selling cost (including real estate agent commission, transfer taxes, title, and settlement fees).
So your calculation is: $505,000 sale price minus $35,350 selling cost (7 percent of sale price) minus $10,000 in improvements minus $200,000 purchase price minus $4,500 in purchase closing costs minus your $250,000 capital gains exemption. Then add $0 to this for depreciation.
This gives you estimated capital gains on your home of $5,150.
Step 2: Calculate your capital gains taxes.
You do this by multiplying your capital gains by your capital gains tax rate.
In this scenario, the capital gains are $5,150, and as noted above, you will pay federal and state taxes of about 25 to 30 percent on the capital gains.
So you will do two calculations to estimate the range between 25 to 30 percent: $5,150 x 0.25 and $5,150 x 0.30.
This means your estimated range of capital gains taxes due will be between $1,288 and $1,545.
Step 3: Calculate your net profit.
You do this by subtracting your loan amount, selling cost and capital gains taxes, from your sale price. The resulting number is your net profit, which is the cash you will actually walk away with.
So your calculation is: $505,000 sale price minus current loan balance of $140,435 minus $35,350 selling cost (7 percent of sale price) minus capital gains taxes (which range from $1,288 to $1,545).
This gives you estimated net profit ranging from $327,670 to $327,927 on the sale.
Putting Real Estate Capital Gains Tax Benefits in Perspective
In our scenario, if the IRS did not allow the $250,000 exemption, your capital gain would be $255,150 and capital gains taxes due would be between $63,788 and $75,545, which would reduce your estimated net profit to somewhere between $253,670 and $265,427.
All scenarios are discussed here in simple terms, and there is a lot of IRS fine print to be aware of that will change based on each homeowner’s financial profile, so consider consulting a tax advisor before selling your home.
So, as you can see, the IRS capital gains exemptions for owners of primary residences can be huge. Homeowners with second homes such as investment properties or vacation homes can also find savings but the rules are a bit different as described below.
Second Home Capital Gains Exclusions
Prior to the Housing Assistance Act of 2008, owners of a second home (vacation or otherwise) could move into that second property, living there for the required 2 years, tDo I hen net most if not all of the profit received on the sale of that house. However, now if you sell that second house you will liable for paying tax on that property based on how long it was your secondary home, even if it is now your primary residence. It is important to keep that in mind when you get ready to sell your second home.
If you are willing to place your profits with a third party bank or title company (1031 exchange) you may be able to avoid paying the capital gains tax. The keys to this approach are you must find an investment property within 15 days of closing on your previous property and you must close on this new property within 6 months. Again, check with a licensed professional before assuming you qualify for a 1031 exchange or will benefit from using it.
Special Capital Gains Exemptions
Qualifying military members are exempt from the 2-year home use requirement (for up to 10 years) because they are often deployed, making it extremely difficult for them to meet the capital gains rule requirements. They get a full exemption when forced to make a permanent change of station to fulfill their military service obligations as part of the “stop the clock” tax exception for those on official extended duty. This exception also applies to some intelligence and Peace Corps personnel.
A recent law change also provides special considerations for surviving widows/widowers when their spouse dies. Surviving spouses are exempt from paying taxes on up to $500,000 profit as long as they sell the home within 2 years from when their spouse died and have not remarried during that time period.
Special allowances may also be available for those getting a divorce, remarried, in a nursing home, moving for health reasons via a doctors recommendation, or as a result of multiple births. When in doubt about whether or not you qualify for an exemption or tax break, consult with a real estate tax attorney to be completely sure what qualifies and what does not.
Final Capital Gains Tax Thoughts
As you can see, there really is no reason to worry about taxes when you put your house on the market. Chances are very good that Uncle Sam will not be able to lay any claim to much if any profits you realize on the sale of your home. However, it is imperative you do your homework and make sure you qualify for a partial or full exemption before putting your home on the market, especially if you believe you will get a tax break.
Currently, taking advantage of the breaks afforded in the current laws is to your advantage, especially on your primary residence, there is no guarantee what the future may hold. As in all real estate transactions, you need to weigh the pros and cons to determine if it is in your best interest to sell now or hold onto your property until a later date. In the meantime, enjoy what you have and keep your existing home(s) well maintained and updated as necessary.
Additional Real Estate Capital Gains Resources
How Does Capital Gains Tax Work via SFGate
Capital Gains Tax Explained by Bill Gassett
*A home might not appreciate from $200,000 to $505,000 over 8 years in the real estate market in Warner Robins GA or anywhere in the U.S. for that matter, but the example above is given for illustrative purposes to show the strong benefit of the IRS real estate capital gains exemption.