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Author: Justin Nabity

Last updated: January 21, 2025

Real Estate

Understanding Capital Gains Tax on House Sales in the US

Many physicians invest in real estate as part of their financial strategy, whether it’s purchasing a primary residence close to work or acquiring rental properties for additional income.

However, when selling off these properties, many overlook an important financial obligation: capital gains tax (CGT).

Without proper planning, a huge portion of your hard-earned gains from selling a home could go to capital gains taxes. This is why understanding how CGT applies to house sales is a vital lesson for physicians.

This detailed resource covers every vital aspect of CGT, including what it is, when it applies, and how to calculate it.

Key Takeaways

  • Capital gains tax (CGT) applies to profits from selling real estate investments.
  • Primary residences may qualify for exemptions, reducing or eliminating CGT liability.
  • Long-term gains offer lower tax rates compared to short-term property sales.
  • Strategies like 1031 exchanges and deductions help minimize or defer CGT.

What Is Capital Gains Tax

Capital Gains Tax (CGT) is a tax on the profit earned from selling an asset, such as real estate, stocks, or other investments.

The “gain” refers to the difference between the selling price and the original purchase price (also known as the cost basis) after accounting for eligible deductions like renovation costs or transaction fees. It’s only the profit, not the entire sale amount, that is subject to taxation.

The purpose of CGT is to ensure that individuals and businesses contribute a share of their earnings from asset sales to the government. However, various exemptions and strategies are available, especially in real estate, to reduce or avoid capital gains taxes.

First, let’s briefly highlight the two classes of capital gains taxes.

Types of Capital Gains Tax

We can further separate CGT into short-term and long-term categories based on the duration an asset is held before its sale. Each type has distinct implications for taxation, which we will discuss below.

Short-term Capital Gains Tax

Short-term capital gains apply to assets sold within a year of their purchase. These gains are typically taxed at your ordinary income tax rates, making them subject to higher tax rates compared to long-term gains.

For instance, if your income tax rate is 24%, your short-term capital gains are taxed at the same rate.

This category primarily impacts individuals who buy and sell assets frequently, such as house flippers or active investors.

If you’re looking to minimize tax liabilities, short-term real estate investments are often not the way to go.

Long-term Capital Gains Tax

On the contrary, long-term capital gains apply to assets held for more than a year before they’re sold. These gains enjoy preferential tax treatment, with rates that are generally lower compared to short-term gains.

In many countries, including the US, long-term capital gain taxes range from 0% to 20%, depending on your income level.

For homeowners, long-term gains can lead to significant tax savings, especially if the property qualifies for certain exemptions, like the primary residence exclusion.

When Does Capital Gains Tax Apply to a House Sale

Generally, if a property is sold at a profit, CGT applies to such sales. However, there are some other factors that further determine whether or not it applies.

1. Selling an Investment Property

Investment properties such as rental homes, vacation houses, or properties held purely for profit qualify for CGT. When these properties are sold, any profit earned is subject to CGT, regardless of how long the property was owned.

2. Selling a Primary Residence

For primary residences, CGT may not apply if certain conditions are met. Here’s what we mean:

Most tax systems offer exemptions for homeowners who have lived in the property as their main residence for a specified period.

In the US, homeowners must have lived in the property as their primary residence for at least 24 months (two years) within the last five years leading up to the sale. These months do not need to be consecutive.

There are also ownership requirements, such as the one stating that the homeowner must have owned the property for at least two years during the five-year period.

If these conditions are met, single homeowners can exclude up to $250,000 of profit, while married couples filing jointly can exclude $500,000.

However, if the property wasn’t your primary residence for the required duration, CGT could be imposed on the portion of time it was used differently.

3. Selling a Second Home

Second homes, such as vacation homes or properties not used as primary residences, are generally subject to CGT. Unlike primary residences, these properties do not qualify for the same exemptions; the full profit from their sale could be taxed.

4. Selling an Inherited Property

While inherited properties are subject to CGT, the tax is calculated differently. The cost basis of the property is “stepped up” to its fair market value at the time of inheritance.

This means you’re taxed only on the gain above that adjusted value when the property is sold.

The calculation section below can explain this through a concrete example.

CGT Exemptions and Deductions

CategoryDescriptionApplicabilityAmount or Details
Primary Residence ExclusionExcludes part of the gain on the sale of a primary residence.Must have lived in the home for 2 of the last 5 years.Up to $250,000 (single) or $500,000 (married filing jointly).
Inherited Property Step-Up BasisAdjusts the cost basis to the fair market value at the time of inheritance.Applies to all inherited properties.No tax on gains accrued before inheritance.
Selling ExpensesDeductions for costs incurred during the sale of the property.Any property sale.Includes realtor fees, legal costs, advertising, and staging expenses.
Improvement CostsIncreases the cost basis by accounting for capital improvements made to the property.Applies to all properties.Examples: New roof, remodeling, or landscaping.
1031 ExchangeDefers CGT by reinvesting the proceeds into a similar property.Investment or business properties only.Gain is deferred, not eliminated. Must reinvest within 180 days.
Partial Primary Residence ExemptionAllows partial exemption if primary residence requirements aren’t fully met due to hardship.Unforeseen circumstances like job relocation or health.Exemption is prorated based on the time lived in the home.
Loss DeductionOffsets capital gains with losses from other asset sales.Applies to all taxable assets.Can also deduct up to $3,000 annually from ordinary income.
Depreciation RecaptureAdjusts taxable gain for depreciation claimed on investment properties.Investment properties only.Depreciation is taxed at ordinary income rates, separate from CGT.
Gifts to CharityTransfers property to avoid CGT, leveraging tax-exempt entities.Charitable donations only.No CGT on property donated to qualified charities.

How to Calculate CGT

Step One: Determine the Sale Price

The sale price is the amount you received from selling the asset. Let’s say you sold a house for $500,000; that’s your sale price.

Step Two: Calculate the Cost Basis

The cost basis is the original purchase price of the asset plus any additional costs, such as renovations or upgrades that increase the property value and transaction costs.

Following up with our example above, let’s say your cost basis includes:

  • Purchase price: $300,000
  • Renovations: $20,000

Total Cost Basis = $320,000

Inherited Properties In the case of selling an inherited property, your cost basis would be calculated using the Fair Market Value of the property + any other additional cost. For instance, if the inherited property is valued at $400,000 and you spend $10,000 on renovations, your cost basis is $410,000.
 

Step Three: Calculate the Capital Gain

Subtract the total cost basis from the sale price to determine your capital gain.

  • Sale price: $500,000
  • Cost basis: $320,000

Capital Gain = $180,000

Step 4: Check for Exemptions or Deductions

Some gains may be exempt or reduced, depending on the type of property and your circumstances.

As previously outlined, you can deduct up to $500,000 if your property meets the primary residence capital gains tax exclusion requirements. You can also deduct selling expenses like realtor fees, staging costs, or advertising.

Let’s say, in our example, your realtor fee is $20,000.

Your Capital Gain (after deductions) = 180,000 – 20,000 = 160,000

Step Five: Determine the Type of Capital Gain

The Difference between the two types of capital gain is the holding duration. If you’ve held the property for a year or less, your taxable income rates would be between 22% and 26%.

Properties held for longer than this qualify for a lower CGT of 0% and 20%.

Step Six: Apply the Tax Rate

Multiply the capital gain by the applicable tax rate to find your CGT liability.

Let’s say our property above was held for the long term:

  • Adjusted Capital Gains: $160,000
  • Tax Rate: 15%

CGT Liability= 160,000 × 0.15 = $24,000

Reporting and Paying Capital Gains Tax

Calculate Your Capital Gain or Loss

Before reporting, calculate your gain or loss. Sale price minus the adjusted cost basis. If the adjusted cost basis exceeds the sale price, you have a loss.

Ensure you keep all relevant documents, such as purchase agreements, receipts for improvements, and sales records, as proof.

Complete IRS Forms

There are two IRS forms necessary in this process: Form 8949 and Form 1040.

IRS Form 8949

Use this form to list details about each taxable asset you sold during the year, including:

  • Description of the property
  • Date of acquisition and sale
  • Sale price and adjusted cost basis
  • Gain or loss for each transaction

IRS Schedule D (Form 1040)

Summarize the information from Form 8949. Separate gains and losses into the short and long term. Then, apply any exemptions or deductions.

Apply Losses to Offset Gains

If losses exceed gains, you can deduct up to $3,000 from your ordinary income annually (or $1,500 if married filing separately). Unused losses can be carried forward to future years.

Determine Your Tax Rate and File Your Tax Return

After determining if your property can be taxed as short or long-term, include Schedule D and Form 8949 with your Form 1040 when filing your federal tax return.

If estimated taxes are required, you may need to pay quarterly installments using Form 1040-ES.

Strategies to Minimize and Avoid CGT

Here are a few proven strategies for minimizing or avoiding capital gains tax:

  • Use a 1031 Exchange: For investments or business properties, defer CGT by reinvesting proceeds into a similar property. You must identify a replacement property within 45 days and complete the purchase within 180 days.

  • Invest in Opportunity Zones: Reinvest gains in Qualified Opportunity Funds (QOFs) to defer CGT until the investment is sold or until the following year. If it’s held for 10+ years, additional appreciation in the QOF investment is tax-free.

  • Gift Assets Strategically: Gifting assets to family members in lower tax brackets or to a charitable organization can reduce or eliminate CGT.

  • Harvest Tax Losses: Review your portfolio before year-end to identify underperforming assets. Sell them to realize losses and offset gains from other investments.

  • Take Advantage of Retirement Accounts: Retirement accounts like Roth and Traditional IRAs can offer tax exemptions on your investments and withdrawals that aren’t subject to CGT.

Learn More With Physicians Thrive

Going into real estate is a brilliant strategy for physicians to manage their finances. However, it’s more important that you understand the tax implications involved.

Capital gain taxes can significantly reduce profit margins on house sales, especially if you don’t know how to navigate tax laws. We’ve provided several ways to avoid or reduce your tax liability and sincerely hope the information above will help you.

You can find other helpful information about investing for physicians in our blog section. You can also check out our investment management services designed to help you thrive as a physician.

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