What is Capital Gains Tax in Real Estate?
Capital gains tax is the tax you pay on the profit from selling a property for more than your cost basis. If you buy a property for $200,000 and sell it for $280,000, your capital gain is $80,000 minus selling costs and basis adjustments. The IRS taxes this gain at different rates depending on how long you held the property and your overall income level.
Short-term vs. long-term capital gains
Short-term capital gains apply to properties held for one year or less. These gains are taxed as ordinary income at your marginal tax rate, which can be 32-37% at the federal level plus state taxes. Most fix-and-flip profits are short-term capital gains because flips typically complete in 3-9 months.
Long-term capital gains apply to properties held for more than one year. These are taxed at preferential rates: 0%, 15%, or 20% depending on taxable income. Most investors pay the 15% rate. A $100,000 profit on a flip might generate $35,000 in federal tax, while the same profit on a buy-and-hold sale might generate only $15,000.
Calculating capital gains on real estate
The formula: Sale Price - Selling Costs - Adjusted Cost Basis = Capital Gain. Your adjusted cost basis includes purchase price, acquisition costs, capital improvements, minus accumulated depreciation. Selling costs include agent commissions, transfer taxes, and closing fees.
Depreciation recapture adds complexity. When you sell a depreciated rental property, the portion of gain attributable to depreciation is taxed at up to 25%, regardless of holding period. The remaining gain above your original basis is taxed at the applicable capital gains rate.
Primary residence exclusion
The Section 121 exclusion allows homeowners to exclude up to $250,000 in capital gains ($500,000 married filing jointly) from the sale of their primary residence, provided they owned and lived in the home for at least 2 of the last 5 years. This exclusion does not apply to investment properties.
Strategies to minimize capital gains
- 1031 exchange: Defer capital gains by reinvesting proceeds into a like-kind property within specific timeframes.
- Installment sale: Spread the gain over multiple tax years by carrying a note from the buyer.
- Opportunity zones: Invest gains into qualified opportunity zone funds for deferral and potential elimination of capital gains.
- Hold for long-term rates: Hold properties longer than one year to qualify for lower rates.
- Harvest losses: Offset gains with losses from other investments sold in the same tax year.
Capital gains and wholesaling
Wholesalers who assign contracts do not technically have capital gains. Assignment fees are typically treated as ordinary income because the wholesaler never takes title. For double-close transactions, the brief ownership creates a short-term capital gain. Some wholesalers operate through S-corps to manage self-employment tax on assignment income.