Tax Guide for Buying & Selling Real Estate in 2022

Tax Guide for Buying & Selling Real Estate in 2022

One of the main benefits behind investing in real estate is the tax breaks that an investor, and owner of an income property, can receive.

However, to understand these tax breaks, there must first be an understanding of how taxes work when buying or selling a property.

Home buyers may ask questions, such as:

  • How does selling a house affect taxes?
  • How does buying a house affect taxes?
  • What taxes are paid when selling a house?
  • Are closing costs tax-deductible?

Landlords and rental property owners need not look any further. The following article covers the ins and outs of capital gains taxes, along with information on how to avoid capital gains taxes during the home selling process.

1. What is Capital Gains Tax?

A capital gains tax is a tax collected by the U.S. Government when an individual sells a house (or something else of value) and makes a profit.

There are two types of capital gains tax in America: short-term capital gains and long-term capital gains.

  • Short-term capital gains are taxes that must be paid to the federal government if a person owns a capital asset (property, stocks, bonds, collectibles, art, etc.) for a year or less before it’s time to sell.
  • Long-term capital gains apply if a property is owned as a capital asset for more than a year before selling it.

Short-term capital gains have a higher sales tax rate than long-term capital gains to discourage short-term trading, which can contribute to market volatility and increased risk. There are also higher transaction fees associated with short-term capital gains.

2. How Do Capital Gains Tax Work?

Short-term capital gains and long-term capital gains cover two different tax rates.

Short-term capital gains tax is always charged at your regular income tax rate, while long-term capital gains tax depends on your tax bracket.

Here’s a snapshot of the way long-term capital gains tax are taxed, according to your income bracket:

Tax Rates for Long-Term Capital Gains 2021

Tax RateTaxable income (Single)Taxable Income (Married, filing separately)Taxable Income (Head of household)Taxable Income (Married, filing jointly)
0%Up to $40,400 Up to $40,400 $54,100Up to $80,800
15%$40,401 to $445,850$40,401 to $250,800$54,101 to $473,750$80,801 to $501,600
20%$445,851 and over$250,801 and over$473,751 and over$501,601 and over

Tax Rates for Long-Term Capital Gains 2022

Tax RateTaxable income (Single)Taxable Income (Married, filing separately)Taxable Income (Head of household)Taxable Income (Married, filing jointly)
0%Up to $41,675 Up to $41,675 $55,800Up to $83,350
15%$41,676 to $459,750$41,676 to $258,600 $55,801 to $488,500$83,351 to $517,200
20% Over $459,750 Over $258,600Over $488,500Over $517,200

For example, in 2021, if a person’s annual income is $445,851 as a single individual and they sell a $300,000 home for $500,000, they will pay $40,000 in capital gains tax (20%) on a profit of $200,000.

In the rare event that a person experiences a long-term capital gain that’s less than a short-term capital loss, they can use their capital loss to offset their capital gain.

If they can also use capital losses to offset other income, it can only be done to a limit of $3,000, or $1,500 if the person filing is married, but filing separately.

Additionally, if the capital losses exceed the limit in one tax year, the person filing can carry over what’s left into the next tax year.

However, most people likely fall into a tax bracket where they’ll never have to pay capital gains tax. Considering this, it’s not something most of us have to worry about.

3. What Taxes Do You Pay When You Sell a House?

Despite the aforementioned, a person will pay taxes when selling a house.

In addition to possibly having to pay capital gains tax on the profits a person receives from a property sale, the person may have to pay other taxes as well.

First, they may pay capital gains tax at the state level as well as the federal level. The following states don’t have income tax and therefore don’t charge capital gains tax:

  • Alaska
  • Florida
  • New Hampshire
  • Nevada
  • South Dakota
  • Tennessee
  • Texas
  • Washington
  • Wyoming

All other states charge a capital gains tax between 2.9% (North Dakota) and 13.33% (California). It’s important to look up your state’s own rules around how they tax capital gains before investing in a property.

Other additional taxes outside of capital gains may include an outstanding property tax on the property sold and a transfer tax on the actual real estate transaction itself. The amount varies depending on the state. Transfer taxes can cost as much as 2.7%, though some states waive them.

It doesn’t matter if the buyer or seller pays the transfer, as long as they are paid to the government. This can be negotiated between the buyer and the seller as part of the sale.

In terms of taxes, that’s all those selling their homes have to worry about, and, generally, the seller doesn’t have as many closing costs to pay as the buyer, but there are several fees over and above taxes that should be considered as part of the closing costs.

These additional expenses include escrow fees, (split evenly between buyer and seller), real estate agent commissions, HOA fees, attorney’s fees, title insurance, appraisal fees, inspection costs, and any hidden fees that may encounter, such as fees for staging, repairs, or moving.

Altogether, closing costs range from 1% to 7% between the buyer and the seller, with the seller typically paying between 1% and 3%.

4. How to Avoid Capital Gains Tax When Selling a House

Even if the person deciding to sell their home does not fall into the income bracket where the capital gains tax rate is zero, there are still ways to avoid paying capital gains tax when selling their property.

1. Sell a Primary Residence

The primary residence is where the seller lived two out of the five years leading to the sale.

If a person is selling their primary residence, $250,000 of profit for an unmarried filing individual, or $500,000 of profit if they’re married and filing their taxes jointly, are excluded from counting toward capital gains tax.

For example, a single taxpayer who purchased a house for $400,000 and sold it for $750,000 made a $350,000 profit on the sale. After applying the $250,000 exemption, they must report a capital gain of $100,000. This is the amount subject to the capital gains tax.

Those with investment properties can do the same thing and live in the property two out of the five years before the sale if they want to take advantage of the primary residence capital gains exclusion.

2. Buy Another Investment Property Right Away

A property owner can defer paying capital gains on the sale of an investment property if they reinvest the proceeds into another “like-kind” investment property. They have 45 days after closing to identify a replacement property and 180 days for the transfer to complete to be able to defer capital gains. A property owner can buy any kind of property, including selling raw land in exchange for an apartment complex as long as you intend to use it as an investment property.

Another example is if the seller exchanges an apartment building for a single-family home that they plan to rent out. This swap is called a 1031 exchange and it allows them to defer capital gains until they sell the property that they just bought.

However, there are rules as to how you use the property if you want to qualify it for a 1031 exchange. These include the following:

  • You cannot buy or sell property you want as a primary residence.
  • You can’t purchase property you want to flip for a profit.
  • While you can sell a property to a related party, you cannot purchase the replacement property from a related party, so you can’t keep it in the family.
  • The property must be in the United States.
  • You use a qualified intermediary to hold the sale proceeds in escrow
  • The new property is of equal or greater value than the property you sell.

3. Limit Rental Use

If a homeowner rents out of their home, it’s no longer a primary residence. This means the owner will lose their capital gains exclusion. To avoid this tax, homeowners can only rent it out for three years and live there for the other two preceding the eventual sale to still meet the primary residence use test.

Plus, if the property owner rents out a room or a floor in their home, such as a basement suite and still uses it as their primary residence for at least two of the five years leading up to its sale like usual, they are also still eligible for the primary residence capital gains exclusion.

They can also use the expenses related to maintaining the portion of their home they rent out to reduce their capital gains tax since they collect rental income. These expenses include repairs and even a portion of the mortgage payment.

However, sellers should be careful about renting a room or a floor in their home to a friend or family member at below-market rent because the IRS may not count any rent that they collect as income and, as a result, they won’t be able to deduct expenses related to the rental use of their home.

It should also be noted that, since the homeowner rents out all or a portion of their home, the IRS may try to recapture depreciation. This means the IRS may try to collect tax on the difference between the sale value and the depreciated value of the home.

An example, this Investopedia article states the following:

if you paid $200,000 for a building and you’re allowed to claim $5,000 in depreciation, then you’ll be treated subsequently as if you had paid $195,000 for the building. If you then sell the real estate, the $5,000 is treated as recapturing those depreciation deductions. The tax rate that applies to the recaptured amount is 25%.

So if you sold the building for $210,000, there would be total capital gains of $15,000. But $5,000 of that figure would be treated as a recapture of the deduction from income. That recaptured amount is taxed as ordinary income but is capped at the maximum rate of 25%. The remaining $10,000 of capital gain would be taxed at one of the 0%, 15%, or 20% rates indicated above.”

4. Track Home Improvement Expenses

The more a person spends on home improvement increases the cost basis in their home, which is the difference between the amount they paid for the property and the amount they sold for, which results in either a capital gain or a capital loss.

Home improvements contribute to making their cost basis larger. The larger their cost basis, the more their capital gains tax is reduced based on their expenses because they’ve added value to their home.

This is particularly useful if the capital gain exceeds the exclusion amount for a primary residence or if they don’t meet the ownership and use tests, such as if it’s an investment property.

For example, if a property owner is taxed at 20% for capital gains on a profit of $200,000, they will owe $40,000 in capital gains tax.

However, expenses related to improving the property are subtracted from that bill. Therefore, if $10,000 is spent on remodeling the kitchen while living there, that $10,000 gets subtracted from the capital gains tax for a total capital gains tax bill of $30,000.

Homeowners should keep receipts and track their expenses for this purpose, a task made easier when using various bookkeeping platforms available to landlords.

Baselane offers expense management services tailored to landlords that can assist with bookkeeping needs, making expenses much more manageable.

5. Track Selling Expenses

Homeowners want to track any expenses associated with selling their home because those expenses bring down any capital gains tax coming from the sale.

Much like tracking home improvement, if the capital gains tax exceeds the primary residence exclusion or it doesn’t meet the criteria for it, expenses associated with the sale can help bring down any capital gains obligations.

Expense tracking isn’t always easy. However, sub-accounts available through Baselane’s Landlord Banking features make tracking expenses to reduce capital gains much easier.

Our Final Thoughts: Taxes When Buying and Selling Real Estate

Capital Gains Tax can be an annoying expense that eats into the profits from selling a property. However, with the various exclusions and loopholes available, most sellers will not have to pay it, or pay a lot less of it, than they may have thought.

FAQs about Buying and Selling Real Estate

What happens if I don’t report capital gains correctly?

If an individual fails to report their capital gains or they under-report capital gains and the IRS finds out, the penalty level will vary.

If it’s a small discrepancy, the IRS will probably correct the tax return and ask for the difference. However, if it’s a larger amount, or, if it's found that an individual has knowingly and willfully decided not to report it, the person can be subject to interest charges on the amount for every month that they didn’t pay and may have to pay penalties or fines.

If it was done in an attempt to commit fraud or tax evasion, the IRS could also seek criminal prosecution.

How are capital gains taxed?

Capital Gains are taxed two ways: short-term capital gains and long-term capital gains.

Short-term capital gains are most common when selling a property within 12 months or less of owning it.

In that case, the person will be taxed on the profit that they gained at their regular income tax rate in the state where they reside. This can go up to 37%.

If the property is for more than a year before selling it, the individual will pay long-term capital gains which are taxed according to their income level at a range of anywhere from 0% to 20%.

Are capital gains considered income?

Yes, indirectly. Short-term capital gains are taxed at the regular income tax rate just like your taxable income. Depending on your tax bracket, your income, and therefore short-term capital gains, can be taxed as high as 37%. Meanwhile, long-term capital gains are given different tax rates of 0%, 15% or 20% and the rate you pay out of those three is also determined by your income level.

However, there are exclusions up to $250,000 for a single individual and $500,00 if a couple is married and filing jointly.

Plus, if the property is your primary residence, there are several ways you can either reduce their capital gains tax obligation or make sure you don’t have to pay it at all.

In this article:
Baselane Banking is now offering 4.19% APY interest

Automated and free Rent Collection, without the stress

Avatar photo
Financial Technology, Real Estate Investing, and Property Management, Accounting and Tax, Finance
Saad started his career as a Certified Public Accountant (CPA) working for a top-tier accounting firm. He was responsible for helping audit alternative investment funds. He later worked at a hedge fund where he was responsible for preparing financial statements and implementing new technology. He also ran a successful private tax practice for five years.

After completing his MBA at Duke, Saad joined The Boston Consulting Group to do management consulting. At BCG his experience spanned several industries and growth projects across Pharma, Retail, and Technology companies. His passion for democratizing finances led him to Plaid, a fintech, where he worked with large Banks and Financial Institutions to make finances and money easier for all.
Tax Guide for Buying & Selling Real Estate in 2022
Tax Guide for Buying & Selling Real Estate in 2022