Man checking on capital gains tax

Capital Gains Tax: What It Is And How To Avoid It

Sarah Sharkey11-minute read
November 04, 2021

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Selling your home for a profit comes with the promise of a big fat check. But if you are earning a profit on the sale of your home, then you might be facing capital gains tax. The possibility of paying taxes can take a bit of the wind out of your home sale sails.

Luckily, there are some legal ways to avoid that unexpected cost. Let’s take a closer look at capital gains tax and how it could impact you.

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What Is Capital Gains Tax?

A capital asset is any type of property you own that has value. A capital asset can be tangible (like a car or a designer purse) or intangible (like a trademark or patent). Your home is also a capital asset. This means that when you sell your home, you might see a capital gain.

Depending on your circumstances, you might need to pay the capital gains tax if you sell your home for more than what you bought it for.

Short-term capital gains tax applies to the sale of assets held for less than a year, while long-term capital gains tax applies to those held for more than a year. The rates for short-term capital gains tax are appreciably higher than for long-term.

How Does Capital Gains Tax Work?

When you’re subject to the capital gains tax, you pay tax on a percentage of the profit you earned selling your asset. The percentage you pay depends on the type of asset you sold, your income, how long you owned the asset and how much money you made on the sale. We’ll go over how you can calculate your potential capital gains tax liability in later sections.

Keep in mind that you only need to pay capital gains taxes on excess income that you earned on the sale. You don’t need to pay the assigned tax rate on the entirety of your sale.

Let’s take a look at an example. Imagine that a decade ago, you bought a home for $250,000. But now, it’s time to move on. So, you put your home on the market and accept an offer for $350,000. In this example, you see a capital gain of $100,000 on your home sale. If your income and asset class put you in the 20% capital gains tax bracket, you pay 20% of your profit. That’s 20% of $100,000, or $20,000. You don’t need to pay 20% of the entire $350,000 sale because you had to spend $250,000 to buy the asset.

The opposite of a capital gain is a capital loss. A capital loss occurs when you sell a capital asset for less money than you bought it for. For example, if you sell the home you bought for $250,000 for $200,000, you saw a capital loss of $50,000.

It’s logical to assume that if you must pay capital gains taxes on the sale of your home, you can also deduct losses from your taxes. Unfortunately, capital losses from the sale of a personal property that you live in aren’t deductible. You can only deduct losses associated with properties that you bought as an investment or rental property.

Capital gains taxes have special laws that dictate how much you pay. One important thing to note about capital gains taxes is that you don’t owe them until you actually sell your investment. If your home steadily rises in value over the years, you don’t need to include this as appreciation on your income. The tax is only levied when you decide to sell. This can allow you to offset your capital gains with capital losses by selling your investments at strategic times.

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Short Term Vs. Long Term Capital Gains Tax

One of the most important factors that influence how much you’ll pay in capital gains tax on real estate is the amount of time you own the property. There are two types of capital gains taxes: short-term and long-term. Let’s look at how these different taxes apply.

Long Term Capital Gains Tax

If you own an asset for more than a year, you’re subject to the long-term capital gains tax when you decide to sell. The specific percentage you’ll pay in long-term capital gains tax depends on your regular income. The more money you earn, the higher the percentage you’ll pay.

Long-term capital gains taxes are usually much more favorable than short-term tax rates. You might even qualify for a 0% long-term capital tax rate if you have a lower income. Long-term capital gains tax rates range from 0% – 20%.

Short Term Capital Gains Tax

If you own an asset for a year or less before you sell it, you’re subject to short-term capital gains taxes. The IRS considers short-term capital gains regular income. This means that any profit from the sale of your asset will contribute to your taxable income for the year. This can push you into a new tax bracket and cause you to pay a higher percentage in taxes for the year.

Let’s look at an example. Imagine that you earn a $40,000 salary and you decide to sell an asset that you’ve owned for less than a year. You sell the asset and see a capital gain of $50,000. When it comes time to do your taxes, the IRS considers both your salary and the money you profited from the sale as regular income. You’ll need to pay taxes on a total of $90,000 for the year.

Short-term capital gains tax rates are much higher than long-term rates. Most investors try to avoid them if they can. Tax rates on short-term gains are the same as federal tax brackets and range from 10% – 37% for 2021, depending on your income.

2021 Capital Gains Tax Rates

Capital gains tax rates are dependent on whether the gain is short-term or long-term. Additionally, your income impacts the tax rate.

Keep in mind that tax rates are based on your net income. Your net income is equal to your gross income minus any deductions you may be entitled to.

If you are subject to a short-term capital gain, the IRS will tax this as regular income. Here are the tax brackets for 2021:

Rate

Income (Unmarried individuals and single filers)

Income (Married individuals filing jointly)

10%

$9,950

$19,900

12%

$9,950

$19,900

22%

$40,525

$81,050

24%

$86,375

$172,750

32%

$164,925

$329,850

35%

$209,425

$418,850

37%

$523,600

$628,300

Any profit you earn gets added to your standard household income if your home sale subjects you to the short-term capital gains tax. This can push you into a new tax bracket and increase what you need to pay for the year.

Long-term capital gains taxes work a little differently. If your home sale subjects you to long-term capital gains taxes, you’ll pay a specific percentage of your profit on the sale. The percentage you pay depends on your income and tax filing status. Here are the long-term capital gains tax rates for 2021.

Filing status

Income boundaries for 0% tax rate

Income boundaries for 15% tax rate

Income boundaries for 20% tax rate

Single

Up to $40,400

$40,401 - $445,850

$445,851+

Head of Household

Up to $54,100

$54,101 - $473,750

$473,751+

Married Filing Jointly

Up to $80,800

$80,801 - $501,600

$501,601+

Married Filing Separately

Up to $40,400

$40,401 - 250,800

$250,801+

The percentage capital gains tax you’ll pay on the sale of a long-term asset depends on your income.

How To Calculate Capital Gains Tax

So, how would capital gains tax play out in your finances?

Let’s say that you’re single and earn $60,000. You sell a property which is subject to the long-term capital gains tax. At the time of sale, you see a $40,000 capital gain. In this example, you would fall into the 15% tax category because your income is more than $40,400 but less than $445,850.

With that, the capital gains tax you make on the sale will be $6,000. This tax will be in addition to your regular income taxes.

Capital Gains Tax Exemptions And Special Rates

Depending on your unique situation, you may encounter tax exemptions or a special rate. Here’s what you should be aware of.

Collectible Items

Capital gains earned from the sale of collectible items will be taxed at 28%, regardless of your income. Collectibles could include assets such as coins or art.

Small-Business Stock

Small-business stock sold for a capital gain will also be taxed at 28%, regardless of your income.

Owner-Occupied Real Estate

Your principal residence is the home that you live in for the majority of the year. Principal residence sales see the biggest capital gains tax exemptions. Capital gain doesn’t include any money that you spent to buy your home. Most homeowners don’t pay any capital gains taxes when they sell their primary residence.

Keep in mind that these exemptions only apply to principal residences. Different rules apply to investment properties.

Investment Property

An investment property is one you own that isn’t your primary residence. It can be anything from a home you buy to flip to a rental property you lease to tenants.

You cannot claim the primary residence exemption on the sale of an investment property. All investment property sales are subject to the capital gains tax. However, you can take advantage of a number of deductions that will minimize your burden when tax season rolls around.

When you sell an investment property, you can consider all of the expenses you incurred buying and selling the property as the total cost of the asset. This total is your cost basis for the investment. The higher your cost basis, the lower your capital gain and the less you’ll pay in taxes.

Note that you can only deduct expenses that you incur, which includes improvements to the home that increase its value. Some examples of improvement costs you can deduct are:

  • Remodeling a bathroom
  • Replacing an old roof with a new, more durable model
  • Constructing a new addition (like an extra bedroom or garage)
  • Installing a home security system

Some examples of expenses that you cannot deduct include:

  • Purely cosmetic upgrades (like painting the bedrooms)
  • Regular maintenance and repair costs

Keep careful documentation of anything that you spend improving the property. This helps you deduct the correct amount at tax time and can be a crucial asset if you’re audited.

Depreciation Deduction

Depreciation deductions account for the wear and tear on property or equipment. The declining value can be assessed by the IRS’s specific depreciation schedules for different types of assets.

Each year, you can deduct a certain amount of the item’s value. If you choose to sell the asset, the depreciation expenses taken over time will be recaptured and taxed at your ordinary income rate.

How To Avoid Capital Gains Tax

Unless you’re selling your principal residence, you probably won’t be able to avoid the capital gains tax altogether. However, there are plenty of ways to reduce what you owe. Here are a few strategies you can use to limit your tax burden. 

  • Hold onto your assets. If at all possible, you should hold onto your investments for at least a year. This helps you avoid paying the expensive short-term capital gains tax. This is especially beneficial if you’re selling a personal property and want to take advantage of the principal residence exemption.
  • Offset capital gains with capital losses. Investors can minimize their capital gains tax liability when they sell their assets after a period of loss. Depending on the type of capital asset you’re holding, you can often use your capital losses to “cancel out” any gain you saw earlier in the year.
  • Sell your investments when your income is the lowest. As we’ve gone over, the percentage you’ll pay on your long-term investments depends on your income. It’s a good idea to sell your investments when your income is lower. If you’re self-employed or on a variable income, keep track of your revenue throughout the year and sell assets when your income is lower. You can also sell your assets after you retire.

If you aren’t sure what the best strategy is for your finances, talk with a tax advisor to explore your options.

Avoiding Capital Gains Tax On A Home Sale

If you are selling your primary residence, you have the chance to avoid a major capital gains tax bill. Some requirements you must meet to classify a property as your principal residence include: 

  • Long-term stays: You must live at the property for most of the year.
  • Distance from work: Your principal residence must be a reasonable distance from your place of employment.
  • Documented proof that you live there: This can include things like voter registration, a tax return, etc.
  • Spousal agreement: If you’re married, your spouse must claim the same primary residence as you.

If you’re selling your principal residence, you’re exempt from a large amount of capital gains from your taxes, according to your filing status.

  • You don’t need to pay any capital gains tax on the first $250,000 of profit on your home if you’re single.
  • You pay 0% capital gains tax on the first $500,000 of profit on your home if you’re married filing jointly.

Before you jump into this option, ensure that you’ve lived in the property for the last two out of five years. Otherwise, the property may not count as your primary residence.

Avoiding Capital Gains Tax On An Investment Property

Although it is more complex, it is possible to avoid capital gains tax on an investment property. The simplest solution is to move into your investment property for at least two years before selling it.

Additionally, you can:

  • Track your expenses incurred by the sale. You can deduct these costs from your profits.
  • Pursue a 1031 exchange. Reinvesting the funds in another investment property can help you avoid the capital gains tax.

As you explore your options, consider consulting a tax professional to determine the best course of action.

The Bottom Line

The tax code can get complicated. But at the end of the day, your income will impact the amount your pay in taxes. If you are planning to sell a property, you can take steps to dramatically reduce your capital gains.

Are you ready to take your finances to the next level? Take advantage of the resources offered on the Rocket HQSM Learning Center.

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Sarah Sharkey

Sarah Sharkey is a personal finance writer that enjoys helping readers learn more about their finances. She has an MS in Business Management from the University of Florida. You can connect with her on LinkedIn or Instagram @adventurousadulting.