Do You Have to Pay Taxes on a Real Estate Sale?

When a property is sold for more than its purchase price, the profit is a capital gain and may be subject to taxation. The amount of tax owed depends on several factors, including whether the property was a primary residence, an investment, or inherited. The length of time the property was held also determines if the profit is a short-term or long-term gain, which have different tax rates.

Federal tax law provides specific rules and exclusions that can reduce or eliminate the tax bill from a real estate transaction. Identifying the type of property sold and the circumstances of the sale will determine how to calculate and report any potential tax liability.

The Primary Residence Exclusion

A tax benefit is available to homeowners selling their primary residence. The Internal Revenue Service (IRS) allows an exclusion of a substantial portion of the gain from such a sale. A single individual can exclude up to $250,000 of the gain, and this amount doubles to $500,000 for a married couple filing a joint tax return. This exclusion can only be claimed once every two years.

To qualify for this exclusion, the seller must satisfy both an ownership test and a use test. The ownership test requires that you owned the home for at least two of the five years before the sale. The use test mandates that you lived in the home as your primary residence for at least two of the same five-year period. These two years do not need to be continuous.

A homeowner who does not meet the two-year ownership and use requirements may still qualify for a partial exclusion. This can occur due to a change in employment, health-related reasons, or other unforeseen circumstances recognized by the IRS. A partial exclusion is calculated based on the portion of the two-year period that the homeowner met the requirements.

For example, a married couple who lives in a home for two full years before selling can exclude a gain of up to $500,000. If they realize a gain of $450,000, the entire amount is excluded. If a single person sells their main home and profits $300,000, the first $250,000 is tax-free, and tax is only owed on the remaining $50,000.

Calculating Your Taxable Gain

The taxable gain from a real estate sale is calculated with a basic formula: the property’s selling price, minus selling expenses, minus the property’s adjusted basis. The result is the capital gain or loss. A positive number indicates a potentially taxable gain.

The selling price is the gross amount the property sold for, from which you subtract allowable selling expenses. These are costs directly associated with the sale, such as real estate broker’s commissions, title insurance fees, legal fees, and advertising costs. For instance, if a home sells for $400,000 and the seller pays $30,000 in commissions and other costs, the amount realized is $370,000.

The adjusted basis starts with the original purchase price of the property. This basis is increased by the cost of capital improvements made during ownership. Capital improvements add value to the home, prolong its life, or adapt it to new uses, such as adding a new room or installing a new roof.

Certain events can decrease the adjusted basis, including previously claimed casualty loss deductions or certain tax credits for home energy improvements. It is important to distinguish between an improvement and a repair. A repair, like painting a room, maintains the home’s condition but does not add to its basis, while an improvement, like replacing all windows, does.

Reporting the Real Estate Sale

The transaction must be reported to the IRS on Form 8949, Sales and Other Dispositions of Capital Assets. On this form, you will detail the property sold, the acquisition and sale dates, the sales price, and the cost basis.

The information from Form 8949 is summarized on Schedule D, Capital Gains and Losses, which is filed with your Form 1040 tax return. Schedule D separates gains into short-term (for property held one year or less) and long-term (for property held more than one year). Long-term capital gains are taxed at lower rates than short-term gains, which are taxed as ordinary income.

You may still need to report the sale even if you qualify for the full exclusion and have no taxable gain. If you receive a Form 1099-S, Proceeds From Real Estate Transactions, you must report the sale on your tax return. This form is issued by the closing agent or lender.

The tax rates for long-term capital gains in 2024 are 0%, 15%, or 20%, depending on your overall taxable income. For the 2024 tax year, a single filer with taxable income up to $47,025 would pay 0% on long-term capital gains. Those with income between $47,026 and $518,900 would pay 15%, and higher earners pay 20%.

Tax Rules for Other Property Sales

The tax rules differ for properties that are not a primary residence. For second homes or vacation properties, the primary residence exclusion does not apply, and any gain is taxable as a capital gain. The holding period still determines the applicable tax rate.

Rental or investment properties have their own tax implications. When these properties are sold, any depreciation claimed during the ownership period may be subject to recapture. This means a portion of the gain equal to the depreciation taken is taxed at a maximum rate of 25%. Investors may defer taxes on the gain by using a 1031 exchange, which involves reinvesting the proceeds into a similar property.

Inherited property receives a “stepped-up basis,” meaning the heir’s cost basis is the property’s fair market value at the date of the original owner’s death, not the original purchase price. For example, if a home was worth $300,000 when inherited, the heir’s basis becomes $300,000. If they later sell it for $310,000, capital gains tax is only owed on the $10,000 profit.