Capital Gains Taxes: Explained

Capital gains tax is a federal tax imposed on the sale of a capital asset, such as a stock, bond, or real estate. This tax is based on the difference between the cost—known as the cost basis—of the asset and its selling price. Its purpose is to tax profits that have been made from the appreciation of an asset over time. In the case of real estate, capital gains tax may be owed on the sale of any type of property, including a primary residence, a second home, and an investment property.

The cost basis of your home typically includes not only what you paid to purchase it but also what you paid to make home improvements over the years. When your cost basis is higher, your exposure to the capital gains tax may be lower. That’s why it’s important to keep receipts for your home improvement expenses. Remodeling projects, expansions, new windows, landscaping, fences, new driveways, and heating and air conditioning systems are all examples of things that might reduce your capital gains tax.

Capital Gains Tax on the Sale of Your Primary Residence

If you sell your primary residence for more than its cost basis, you could be subject to taxes on the profit you make from the sale. The good news is that you may be able avoid or at least reduce paying capital gains on primary home sales.

However, it is important to note that the property must have been used as your primary home for at least two of the five years preceding the sale in order to qualify for a capital gain exclusion. If the property was used as your primary residence for less than two years, a portion of the capital gains may still be excluded.

In 2023, you can exclude:

• $250,000 of capital gains on real estate if you are single, or
• $500,000 of capital gains on real estate if you are married and filing jointly.

For example, if your primary residence has cost basis of $200,000 and you sell it for $300,000, you will have a capital gain of $100,000. If the property was used as your primary residence for at least two of the five years preceding the sale, the entire $100,000 gain would be excluded from federal taxation. State tax may still apply on the sale.

Capital Gains Tax on the Sale of a Second Home or Investment Property

Capital gains tax on the sale of a secondary residence, a vacation home, or an investment property works differently. Unless the property was used as your primary residence for two of the preceding five years, in most cases, you will pay capital gains tax on the gain. One thing to note: Special rules do apply to a gain on the sale of rental property for which you took depreciation deductions.

How Much Will I Owe in Capital Gains?

Capital gains tax for married individuals and single individuals is generally calculated in the same way, based on the profit made from the sale of a capital asset. The main difference is determined by the tax bracket in which the individual or couple falls and their tax filing status. Those who fall into a higher tax bracket may pay a higher capital gains tax rate than those who fall into a lower tax bracket.

Capital gains tax rates depend on how long the property has been held. Properties held for more than one year are taxed at more favorable long-term capital gains tax rates, while those held for one year or less are taxed at short-term capital gains tax rates.

In 2023, the following capital gain tax rates apply:

• Long-term capital gains (LTCG) are taxed at 0 percent, 15 percent, or 20 percent, based on an individual’s modified adjusted gross income (MAGI). An additional 3.8 percent tax may also apply.

• Short-term capital gains are taxed at the same rate as ordinary income, which ranges from 10 percent to 37 percent.

Remember that these tax rates are subject to change, and it’s always a good idea to consult a tax professional or check the latest tax laws for updates. Also, some states have their own capital gains tax rates, so it’s important to consider both federal and state tax implications when calculating capital gains tax liability. If you need help deciding when to sell a home, speak to your financial and tax advisors who can help you understand the short- and long-term financial consequences.

About the Author: Julie Fuller is a wealth management financial advisor based in West Des Moines, IA. She provides an array of services, including family office, investment management, life and long-term care insurance, as well as philanthropic planning. She holds a Bachelor of Business Administration degree in accounting from Iowa State University in Ames, Iowa, and the designations of CERTIFIED FINANCIAL PLANNER™ (CFP®) and Certified Public Accountant (CPA).

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