If you make a profit from the sale of real estate, the IRS imposes a tax on your profit – not on the property's total sales price. This profit is called a capital gain. But not all capital gains are equally taxed. Your tax liability depends on whether your profit is a short-term capital gain or a long-term capital gain. Simply put, short-term capital gains are imposed on profits earned when an asset is held for less than a year, while long-term capital gains are implemented on assets which were sold after a year of ownership.
For tax year 2018, the IRS taxes short-term capital gains at the same rate as your ordinary income, while long-term capital gains are typically subject to a tax rate of 0%, 15% or 20%, depending on your tax bracket.
Long-Term vs. Short-Term Capital Gains
The tax rate on capital gains depends on how long you hold your property before you sell it. If you own it for just one year or less, you have a short-term gain if you sell for a profit. If you hold the property for one year or more, it’s a long-term gain.
The tax implications can be significant so it might be worth waiting until you cross over that one-year line if you're on the fence about when to sell. Long-term capital gains tax rates are more advantageous.
The Different Tax Rates
You’ll pay capital gains tax according to your tax bracket if you have a short-term gain, and your tax bracket will depend on your total taxable income when your profit is added on to any other income you have for the year. For example, if you're single and earn less than $38,700 in 2018, you'd fall into the 10-percent tax bracket. But if a short-term gain brings your income up to $80,000, you’d fall into a 22-percent tax bracket.
Long-term taxable gains are taxed at zero percent, 10 percent and 20 percent. Yes, zero percent. You won’t pay capital gains tax if you hold your property for longer than a year, you’re single, and your overall income was $38,600 or less. At income of $80,000, you’d pay 15 percent, but that’s still a lot better than 22 percent for a short-term gain. Only single taxpayers earning more than $425,800 as of 2018 have to worry about the 20 percent capital gains rate. Most taxpayers pay 15 percent on long-term gains.
Offsetting Gains With Losses
You can potentially offset some or all of your capital gains with capital losses. You might have realized a $10,000 profit on House A, but you lost $5,000 when you sold another asset. All other things being equal – such as that they’re both long-term gains – your actual taxable gain is only $5,000. You can subtract the $5,000 you lost from your $10,000 gain. Your gains or losses don’t all have to be the result of selling real estate.
Real Estate as Inventory
Gains can also be taxed differently depending on whether you’re in the business of buying and selling real estate for profit or if you’re simply selling your home. If you buy and sell properties as a business, any profits you realize aren’t capital gains. That money is income and that means it’s taxable according to your tax bracket, just like short-term capital gains are. The properties you own for resale are inventory. This can result in a much more complicated tax situation that often requires the help of a tax professional.
If you purchase a single property as an investment, however, your profits are capital gains.
The Home Sales Exclusion
A separate batch of rules applies if the property you’re selling is your home. You might dodge paying any capital gains tax in this case, and many homeowners do.
You must actually live in the property for two out of the last five years to qualify. If you’re married, you and your spouse must each have used the property as your residence for two years although those years don’t have to be concurrent. You must also have owned the property for two of the last five years, but the ownership and residency requirements don’t have to occur simultaneously. Either spouse can meet the ownership rule to qualify if you're married. Some exceptions apply for the U.S. military and if you’re forced to move under certain circumstances, such as if a job change forces you to relocate.
You’re limited to claiming this exclusion from capital gains tax only once every two years because of these rules. You can’t claim it if you’ve done so in the last two years, and if you’re married, neither you nor your spouse can have claimed it.
If you meet all these criteria and you’re single, you can realize a gain of up to $250,000 without paying any capital gains tax. This doubles to $500,000 if you’re married and file a joint married return. Vacation homes and rental properties sometimes qualify if you used either as your residence at some point, but the amount of the exemption would be less.
You can subtract the applicable exemption amount from your profit and you would only owe capital gains tax on the balance.
Beverly Bird has been writing professionally for over 30 years. She specializes in personal finance and w, bankruptcy, and she writes as the tax expert for The Balance.