Capital Gains Tax on Real Estate: What You Need To Know

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The idea of capital gains tax can hamper the prospect of selling a property and gaining profit. Having to pay capital gains tax affects your net profit from selling the real estate property.

To help potentially minimize your tax liabilities, Realized 1031 has created a comprehensive guide about capital gains tax on real estate. We will discuss ways to calculate taxes, strategies to minimize payments, and other related topics. Keep reading to learn more.

Capital Gains on Real Estate

When you sell an appreciated asset, you earn a profit. This profit is called capital gains. In real estate, capital gains are the amount over the purchase price. There are two types of capital gains: short-term and long-term. Short-term capital gains apply to assets held for a year or less, while long-term capital gains apply to assets held for more than a year.

What Is Capital Gains Tax?

Since you made a profit from selling the real estate property, whether it’s a home or land, you will need to pay taxes. Capital gains tax is the name for the tax levied on the profit of the sale. At the most basic level, the taxable income comes from the difference between the original purchase price and the sales price. The rates depend on your income tax bracket. The IRS has three classifications for long-term capital gains: 0%, 15%, and 20%.

However, like any other type of tax, you can make adjustments to help offset the payments. These include the 1031 exchange, holding periods, and tax deductions from expenses.

Example Calculations for Capital Gains Tax

Let’s explore some example calculations to help you gain a clearer understanding of how capital gains taxes work.

Residential Property

Single-family homes and similar residential properties enjoy certain exemptions when it comes to capital gains tax. One of the most prominent of these privileges is the Section 121 Exclusion. According to this rule, single home sellers are exempted from paying capital gains tax up to $250,000. Married couples can enjoy a higher limit of $500,000. Of course, not everyone is qualified. You must meet the ownership qualifications to leverage this exemption.

Here is an example tax calculation:

(Selling Price) $500,000 – (Purchase Price) $400,000 = (Capital Gains) $100,000

Applying Section 121 Exclusion = No capital gains tax since the value is below $250,000

Capital Gains Tax on Land

Land real estate transactions follow a similar calculation method but have unique tax considerations due to the nature of land as an investment.

Here’s an example:

(Selling Price) $900,000 – (Purchase Price) $500,000 = (Capital Gains) $400,000

($400,000) x (20% Tax Bracket) = (Capital Gains Tax) $80,000

Having to pay $80,000 for capital gains is a huge loss. Thankfully, there are ways to help reduce your tax obligations, like the 1031 exchange.

Capital Gains Tax on Commercial Buildings

Commercial buildings are a broad category that may include retail spaces, office buildings, and industrial facilities. An important consideration for such properties is depreciation recapture. This is a tax provision that applies when you sell a depreciable property for more than its adjusted cost basis, and the IRS can recapture up to 25% of the amount.

For example:

(Purchase Price) $700,000 – (Depreciation) $100,000 = (Adjusted Property Value) $600,000

(Selling Price) $900,000 – (Adjusted Property Value) $600,000 = (Capital Gains) $300,000

(Recaptured) $100,000 x (25% maximum rate) = (Regular Income Tax) $25,000

(Leftover Capital Gains) $200,000 x (20% Tax Bracket) = $40,000

$25,000 + $40,000 = (Total Tax Due) $65,000

When Do You Pay Cap Gains Tax on Real Estate?

You typically pay the capital gains tax within the tax year in which the property is sold. For example, if you sell a property in 2024, you must report the gain and pay any resulting tax when you file your 2024 tax return in 2025. In some cases, the IRS allows quarterly payments to help you manage your tax liability, especially if the amount is high. Check out our more expansive discussion about this topic.

Strategies To Help Minimize Capital Gains Tax

Section 121 Exclusion is reserved only for certain types of real estate property owners. However, there are several other ways to reduce capital gains taxes and keep most of your profits. Here are some of the popular options.

Holding the Sale

All the calculations we provided above are for long-term capital gains. Short-term capital gains have higher rates — up to 37% for those in the highest tax brackets. Thus, holding on to an asset for longer is generally considered a way to lower your tax payments. However, everyone's situation is different, and these decisions need to be based on your individual needs and with the help of a professional. As we mentioned, long-term capital gains taxes start applying one year after you start owning the asset.

1031 Exchanges

Named after Section 1031 of the Internal Revenue Code, a 1031 exchange or like-kind exchange allows you to defer paying capital gains tax by reinvesting the proceeds from the sale of one property into a similar property.

Tax Loss Harvesting

It may seem counterintuitive to harvest a loss, but it’s possible. Tax loss harvesting is a process that involves selling other investments at a loss to offset your capital gains. The value you lost can be used to offset capital gains. For example, Asset A is down by $10,000. Selling Asset A at a loss allows you to reduce $10,000 when you sell Asset B, which earned $100,000 in capital gains. The taxable income becomes $90,000, thanks to tax loss harvesting.

Wrapping Up: Cap Gains on Real Estate and Your Tax Obligations

Capital gains tax is a significant factor in real estate investment, affecting both profit and tax liability. Knowing how this tax obligation works can help you manage your tax burdens and make sensible financial decisions. Working with tax and investment experts like our team at Realized 1031 can help you navigate the complexity of capital gains taxes.

Sources

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.

Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.

Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.

Hypothetical examples shown are for illustrative purposes only.