How to minimize capital gains on real estate
Tax-saving strategies for when you sell your home
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Selling your home can be rewarding, especially when you earn a significant profit. But one thing that can cut into these profits is capital gains tax.
Capital gains tax is the tax imposed on the profits made from selling an asset, such as real estate, for more than its original purchase price. However, it is possible to sell your home without being hit with a hefty tax bill.
- The IRS allows for an exclusion of up to $250,000 for single filers (or $500,000 for joint returns) for capital gains on the sale of a primary residence if certain requirements are met.
- Qualified improvements can be added to the property's cost basis, reducing the taxable capital gains.
- A 1031 exchange allows for the deferral of capital gains tax by reinvesting the proceeds from the sale of one property into a similar property.
What is capital gains tax?
Capital gains tax is a tax on the profit made from an investment, such as stocks, collectibles or real estate. If you sell an asset for more than you paid for it, the profit you make is considered a capital gain, and the IRS wants its cut of the proceeds.
To calculate capital gains tax on real estate, subtract the property’s adjusted basis from its selling price. The adjusted basis is generally the original purchase price plus any qualifying improvements made over time.
If you've owned the property for less than a year, you’ll pay short-term capital gains tax on your profits. If you’ve owned it for longer, you’ll pay long-term capital gains tax on your profits. Short-term gains tax is typically higher than long-term gains tax.
When do you have to pay capital gains tax on real estate?
You only have to pay capital gains tax when you sell a property for a profit. You’ll pay the capital gains tax when you file your tax return for the year in which you sold the property.
Expect to pay capital gains tax on the following transactions:
- Sale of a primary residence. The IRS allows homeowners to make a profit of up to $250,000 for single filers and $500,000 for joint returns on their primary residence without having to pay capital gains tax on it. If you make a profit on your home and it exceeds those amounts, you will have to pay capital gains tax on the difference.
- Sale of an investment property. If you sell a property you own as an investment, such as a rental property or a property you flipped, it can result in having to pay capital gains tax on the profit made from the sale.
- Sale of a second home or vacation property. Depending on how long you’ve owned your additional property and how you used it, you could pay capital gains tax when you sell it. For example, if you rented out this property often, your capital gains tax could be less after deducting improvements and upkeep. If you lived in the home for two years out of the past five years, you could avoid the tax altogether.
» MORE: How does a mortgage work?
Strategies for avoiding capital gains tax
Even if you have made a profit on the sale of either your own home or an investment property, there are ways to avoid paying capital gains tax.
- Hold real estate for the maximum tax advantage
- If you've lived in your home as your primary residence for at least two of the past five years, you may qualify for the primary residence exclusion. Planning your sale around the two-year rule can save you a lot of money.
“Minimizing tax when selling real estate is often a matter of how much flexibility you have,” said Jeremy Babener, an expert advisor to financial advisors, referring to how long you’re able to hold on to your property or how you use your proceeds.
This is also a strategy that home flippers do — they live in a home for two years while remodeling it to avoid paying capital gains tax.
- Leverage the power of 1031 exchange
- A 1031 exchange is an option for real estate investors, but note that it can’t be used for selling your own residence.
“If you can keep your sale proceeds invested, you can defer tax by reinvesting in another property through a 1031 [exchange],” said Joe Di Gangi, a financial advisor. “Just make sure you've already identified the replacement property before you sell.”
This strategy is smart for real estate investors because they can continually sell one property for a profit and purchase a more valuable property without worrying about capital gains.
- Use capital improvements and deductions
- If you buy a property, either to live in or for investment purposes, you can deduct any expenses spent on remodeling or repair that are considered capital improvements. It’s important to document and save proof of any renovations you do to the property so you can deduct it for the year you must report capital gains.
For example, if you purchased a $200,000 home, paid $50,000 for remodeling costs and then sold it for $300,000, you would only have to pay capital gains tax on $50,000 (not $100,000).
- Use tax-efficient investment structures
- “If you have enough discretion that you can focus your investment on properties in opportunity zones, you can often increase your after-tax return significantly,” said Babener.
“Opportunity zones,” established under the Tax Cuts and Jobs Act of 2017, incentivize investment in economically distressed areas. By investing in properties in opportunity zones through qualified opportunity funds (QOFs), investors can defer tax on any prior eligible gain.
Additionally, if they hold this investment for at least 10 years, the appreciation in the QOF investment is never taxed.
Keeping up with capital gains tax laws
Tax laws can change often, so it’s important to stay up to date on the current tax laws around real estate capital gain taxes.
Additionally, hiring a certified public accountant or tax expert before you sell your property can help you make the right moves to avoid excess capital gains tax or double taxation. They can also ensure you haven’t missed any eligible deductions and exemptions and keep you compliant with all relevant tax regulations.
Can I offset capital gains with capital losses from other investments?
Yes, you can offset capital gains with capital losses from other investments and reduce your overall tax liability. However, capital losses are first used to offset capital gains of the same type, meaning your short-term losses will be deducted from your short-term gains first.
Are there any tax benefits for making energy-efficient improvements to real estate?
Yes, there are tax benefits for making energy-efficient improvements to real estate. Programs can vary by state and county, but you may be eligible for tax credits, deductions or incentives for installing energy-efficient systems, such as solar panels, energy-efficient windows or insulation.
How does depreciation recapture affect capital gains tax on real estate?
Depreciation recapture happens when you report the profit from a property sale as ordinary income rather than a capital gain. Since capital gains are taxed at a higher rate, the IRS may recapture a portion of the depreciation you claimed as ordinary income, subjecting it to a higher tax rate.
What are the tax implications of converting a rental property into a primary residence?
If you convert a rental property into your primary residence, you may be eligible for certain tax benefits, such as the ability to exclude capital gains when you sell the property. To avoid capital gains this way, you will need to make the rental your primary residence for two years or make enough capital improvements on it to cancel out the gains.
- Article sources
- ConsumerAffairs writers primarily rely on government data, industry experts and original research from other reputable publications to inform their work. Specific sources for this article include:
- IRS, "Topic No. 701, Sale of Your Home." Accessed June 20, 2023.
- California Franchise Tax Board, “Income from the sale of your home." Accessed June 20, 2023.
- IRS, “Opportunity Zones." Accessed June 23, 2023.
- IRS, “Opportunity Zones Frequently Asked Questions." Accessed June 23, 2023.
- TurboTax, “Capital Gains and Losses." Accessed June 23, 2023.
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