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What are capital gains and capital gains taxes?

Capital gains occur when an asset is sold for more than what was paid. For example, if you buy a share of stock for $40 and later sell that share for $100, you have a capital gain of $60. The tax on that profit is called capital gains tax.

Capital gains are either long-term or short-term. If you hold an asset for a year or less, you may be subject to short-term capital gains taxes. Assets held for more than one year may be subject to long-term capital gains taxes, which are lower than short-term capital gains taxes. Net short-term capital gains are typically taxed at the same rate as ordinary income. Net long-term capital gains receive favorable tax rates, which typically do not exceed 15% for most individual taxpayers.

How are capital gains taxes calculated in real estate?

Capital gains taxes on the sale of real estate work generally the same as they do on the sale of other capital assets. If you own the real estate for more than one year prior to the date of sale, then you will be taxed at the long-term capital gains rates. If you own the real estate for one year or less prior to the sale, then you will be taxed at the short-term capital gains rates. The exact capital gains tax on the sale of real estate depends on a number of factors, such as your marital status, tax bracket, how long you owned the real estate prior to the sale, and whether the real estate was your primary residence or an investment property.

For 2022, Single taxpayers with long-term capital gains up to $41,675 and married couples filing jointly with long-term capital gains up to $83,350 may not pay any long-term capital gains taxes for tax year 2022. Single taxpayers may pay a long-term capital gains tax rate tax of 15% for capital gains between $41,676 and $459,750. Married couples that are filing jointly may pay a long-term capital gains tax rate of 15% for capital gains between $83,351 and $517,200. The long-term capital gains tax rate is currently capped at 20%.

To determine the amount of capital gains on the sale of real estate, subtract your basis in the real estate from the sale price of the real estate. Your basis in the real estate is generally the amount that you paid for the real estate plus closing costs, real estate agent fees, and capital improvements. Capital improvements are significant improvements or repairs to the real estate, such as a new roof or new septic system. The sale of real estate is generally reported on your individual tax return using Form 8949 and Schedule D. Because of the complexity of reporting the sale of real estate, you may want to have a tax professional complete or review your tax return.

How do short-term and long-term capital gains affect taxes?

When a capital asset is sold for a profit, the taxpayer will report either a short-term capital gain or a long-term capital gain. Because long-term capital gains have preferential tax rates, a taxpayer would typically prefer to have a long-term capital gain instead of a short-term capital gain.

Short-term capital gains are taxed as ordinary income. For 2022, the highest tax rate for an individual is 37%. Because of the higher tax rate, taxpayers will often hold an asset for more than one year so that the capital gains will be subject to the more favorable long-term capital gains tax rates.

Long-term capital gains are taxed at either 0%, 15%, or 20%, depending on the amount of other income the taxpayer is reporting. Most taxpayers pay a long-term capital gains tax of 15% or less. In addition to long-term capital gains taxes, some taxpayers may also be subject to Net Investment Income Tax (NIIT) on their long-term capital gains. The NIIT is an additional 3.8% tax that applies in certain situations for taxpayers with income above certain thresholds. NIIT applies for single taxpayers with modified adjusted gross income exceeding $200,000 and married filing jointly taxpayers with modified adjusted gross income exceeding $250,000. Because of NIIT, the total federal tax on long-term capital gains may be as high as 23.8%.

How can I avoid capital gains taxes?

One of the most common ways to avoid capital gains taxes when selling your primary residence is to claim a Section 121 exclusion (also known as the primary residence exclusion). To qualify for a primary residence exclusion on the sale of your home, you must pass the ownership test and the use test. You are generally eligible for the exclusion if you owned and used the residence as your main home for at least two years during the five-year period ending on the date of the sale of the residence. A single taxpayer who qualifies for the exclusion can exclude up to $250,000 of capital gain from the sale of a primary residence, and a married couple filing jointly can exclude up to $500,000 of capital gain. Because the tax benefits are significant, taxpayers will sometimes move into an investment or rental property for two years prior to selling the property so that the exclusion will apply. If you are thinking about selling real estate but do not currently qualify for the primary residence exclusion, a Rocket Lawyer network attorney can help you determine the steps to take to ensure that you qualify for this valuable exclusion.

There are other ways to reduce capital gains taxes when selling real estate. If you are selling investment property, you may be able to do a 1031 exchange. In a 1031 exchange, you essentially swap one real estate investment property for a different real estate investment property and defer the capital gains on the transaction. Special rules apply when conducting a 1031 exchange, so working with an attorney or tax professional can help make the process easier.

Capital gains taxes may also be reduced by adding expenses such as closing cost, realtor fees, and capital repairs and improvements to your basis. Increasing your basis directly reduces the amount of net capital gains. Finally, you may be able to use capital losses from the sale of other assets to offset the capital gains of selling your real estate. For example, if you sell stocks for a long-term loss of $20,000 and you have $50,000 of long-term capital gains from selling real estate, you can subtract the capital loss from the capital gain to lower your net capital gain to $30,000.

With the right planning, and some tax and legal help, you may be able to significantly reduce the capital gains taxes resulting from the sale of real estate.

This article contains general legal information and does not contain legal advice. Rocket Lawyer is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.

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