When you start digging into the tax code – not something we’d recommend unless you are suffering from severe insomnia – you’ll quickly notice that there are a seemingly endless number of taxes.
Fortunately, many of these taxes are highly specialized and don’t affect most people. However, some of these taxes occasionally pop up in media stories, which can lead to confusion.
You have probably heard of the capital gains tax somewhere, but if you don’t know what it is or if it will affect you, you’re not alone. In this article, we’ll provide a quick review of the capital gains tax and explain why it’s something you probably don’t have to worry about.
Understanding a Capital Gain
Simply put, a capital gain, is the positive difference between the purchase price of an asset and its selling price. So, for example, let’s say that you purchased a piece of art by an unknown artist for $100. Over the next five years, the artist shot to fame, and the little portrait hanging over your mantel is now worth $10,000. Good job! If you sell the artwork, your capital gain will be $9,900.
You can earn capital gains on almost anything, but the most common items are the sale of property (like your home), a business, stocks and mutual funds, and collectibles. It should be noted that if you lose money, that is considered a loss, not a capital gain.
It shouldn’t surprise you that the IRS isn’t about to let you pocket all that sweet profit without taking its cut, which leads us to the capital gains tax.
Taking Its Share
The government has a special tax that it places on all capital gains. It is creatively called the capital gains tax. Now, before you begin freaking out about selling your house in the near future, there are two reasons that you really shouldn’t worry about the capital gains tax.
The first reason is that the capital gains tax rate is actually lower than the income tax rate. For example, the highest amount of capital gains tax that you can possibly pay is 28%, while the highest income tax rate is 39.6%. The amount of capital gains tax you will pay depends on what type of asset you are selling and your income.
The lower your income, the lower the rate of capital gains tax you will have to pay. In fact, if you pay 15% income tax or less, you don’t have to pay any capital gains tax at all on most assets, including real estate and most kinds of stocks.
Selling Real Estate
The second reason you shouldn’t worry about capital gains tax is that 99% of homeowners don’t have to pay it when they sell their homes. Many Americans only encounter a capital gain when they sell their home. Setting aside the housing bubble crisis, home prices tend to rise over time, which means that if you’ve lived in your house for several years, chances are you can sell it for a profit and recognize a capital gain.
Fortunately, there is a very sweet exemption in the capital gains tax law. If you are selling your primary residence, then you can enjoy a capital gains exemption of $250,000 as an individual or $500,000 as a couple.
That means as long as you don’t earn a profit of over $250,000 / $500,000, you won’t have to pay any taxes on your capital gains. As if that weren’t nice enough, you can often deduct money you spent on improving or fixing the home from your capital gains calculation.
Of course, there are some caveats. In order to receive the capital gains tax exemption, you must have lived in your home for at least two of the last five years before you sell. Also, as mentioned, this must be your primary residence. If you sell your vacation home or rental property at a profit, then you’ll have to pay a capital gains tax.
When Should You Worry About Capital Gains?
There are a few instances when you may need to pay capital gains taxes. As we just saw, you’ll have to pay capital gains taxes on profit you earn by selling any property that is not your primary residence. If you are a business owner, you may get hit with capital gains on your business sale.
Stocks within a retirement account are usually safe from the capital gain tax, but earnings on stocks and mutual funds within your normal investment portfolio will likely get hit with capital gains taxes when you sell them.
If you buy and sell your stocks too quickly, you could be looking at higher taxes. (Learn more about paying taxes on investment gains.)
Want to learn more about taxes? Take a look at our taxes article archive or increase your financial IQ by starting a Money Club.
My 92 year old sister-in-law, living in Vienna, VA, is planning to sell her home/property. She has lived there for over 50 years. It is in a culdesac where older homes are being torn down and large homes are being built next to her. She has been offered at least $600,00 for the property, but is not up to understanding what this would mean as regards capital gains. Her husband passed away over 30 years ago. Her annual income is less than $35,000. The only improvements would be a refurbished bathroom and several roof replacements. She has difficulty making decisions. She is totally competent with a sound mind. Should she be seeing some legal person to see where this will go? Thanks for your response.
If she is ready to sell the property, then she should do so. She’ll owe some taxes, but whatever they are, they will be just a fraction of what she will receive in the sale. Her capital gain will be the sales price, less the cost of sale, and less her tax basis. If she and her husband owned the property jointly at the time of his death over 30 years ago, his half will receive an increase in tax basis to 50% of the value of the property at the time of his death. The real estate agent will probably be able to give her an estimate of that value. Her half would be limited to 50% of the original cost of the property. The tax basis for his half will be increased by 50% of the cost of any improvements made after his death. The tax basis for her half will be increased by 50% of all improvements made. I suggest that she gather together the paperwork and figures for the original cost, the value at his death, and the approximate dates and costs of improvements made. Provide that information to a tax accountant along with a copy of her prior year’s tax return, and the accountant can compute the approximate amount of taxes that will be due. I’m guessing the taxes, federal and state, will be somewhere around $100,000-$125,000 combined.
MY MOTHER IN LAW LIVES IN CALIFORNIA. SHE IS A WIDOW 97 YRS OLD. OWNS A HOME. AND LIVES IN A ASSISTED LIVING FACILITY, NO RENTERS. HER HUSBAND PASSED 10 YEARS AGO. I HAVE BEEN READING ALOT OF MATERIAL CONCERNING CGTAX IN CALIFORNIA AND ABOUT TAX WAIVERS AND THE FED’S 1997 TAX RELIEF PROGRAM THAT HAS INCREASED TO $1.7m THIS YEAR 2021. MAKING IT SHORT USING THE FED 97 PROGRAM SHE WILL NOT BE TAXED ON HER HOME BECAUSE IT IS UNDER THEIR 2021 LIMIT. CALIFORNIA SEEMED TO
FOLLOW THE FED PROGRAM BUT I DONT KNOW IF IT THE SAME AS THE FED $1.7M NO CG TAX WILL BE APPLIED??? THANKS
There is a $250,000 capital gains exclusion for the sale of a residence where a taxpayer has lived for 2 of the 5 years prior to sale. That rule came into being in the 1997 tax relief legislation. But she may not qualify if she’s been absent for more than 3 years from the home. You’ll need to check with a tax preparer to find out if there’s an exception for circumstances such as hers.
Hello Ginita
My wife of nearly 40 years put the home she inherited from her parents into our trust prior to her death this Spring. It has been rented for 7 years. In California, we are able to transfer the taxable base from a primary residence when purchasing another home after the first home is sold. Does the “two in the last 5 years” statute specify 730 days in 5 years, or IN two of the last 5 years (i.e.December of 2020 until January 2022? Is the IRS accepting real estate sites (Zillow, Realtor dot com etc) date-of-death valuations for capital gains calculations? Our home dropped by a significant amount since March 2021
Thank you.
OK, sounds like you are confusing two things. Let’s talk about your tax basis when you sell the house and compute your taxable gain. The house probably got a stepped-up tax basis to the value on the date of her death. Zillow and the like are not reliable sources of value, so you can certainly use those, but they would not be acceptable if the IRS questioned the value you use. If there is a gain and you lived in the home for two of the prior five years, then you could use your $250,000 exclusion against capital gains for selling your primary residence. But since the home has been rented out, it doesn’t sound like it is your principal residence and that wouldn’t apply. If you convert the rental to your principal residence, you will need to live there for five years to use your exclusion. And even then, there will be depreciation recapture and a portion of the gain that is taxable since it was used as a rental since 2008.
Now let’s talk about property taxes in California. If you sell your home and buy a new one of the same or lesser value, you can transfer your assessed value from your old home to your new one. It must have been your primary residence when sold, and it sounds like that isn’t the case for the property you are talking about since it is a rental and you live elsewhere.
Thank you for your response. There are two homes that I am dealing with, both of them are in our trust. I am the sole trustee and beneficiary of the trust. My primary residence has been in the family for 25 years, and I have been here for the last seven years And I am considering turning it into a rental for three years if it makes more sense to then sell the current primary residence, or seek the lower taxable base from the other one. The smaller rental home has a taxable base of $80,000, and the one I am in now is $280,000 with quadruple the property tax. We lived in the other home for two years 2012-2014 while caring for my mother-in-law. Is what you’re saying is that I would need to re-establish residency for the rental home for a period of five years to reestablish it as a primary residence? Not two out of the last five years? Regarding selling a primary residence, does the “two in the last 5 years” statute specify 730 days/24 months in 5 years, or IN two of the last 5 years (i.e.December of 2020 until January 2022)
Thank you
Any two years out of the past five years counts, it doesn’t have to be the final five years. If you convert a rental to a primary residence, for the purpose of the Sec. 121 capital gain exclusion of $250,000 you must reside there for five years after converting it to a principal residence in order to claim the exclusion. And a portion of the gain cannot be excluded and will be taxable. You will probably need to consult with your accountant to see what the tax consequences would be to you for the various options, so you can make a good informed decision.
do you have any recommendations for a CPA or EA or someone who can advise about taxes
and maybe take a look as an independent advisor to your other accounts etc?
You’ll want someone in your locale, so ask around of people who might know your local professionals. I’m sure you’ll be able to find someone.
I currently have no income and live with my husband on his pension which is low enough to have no tax liability. A couple of years ago I bought (using my savings and borrowing some cash against my credit card) a rundown house, fixed it, and recently sold for profit. Now, with his pension added, our combined income is taxable. Can we file married but separate so that I report capital gain and he reports his pension only? I tried the math, and it proves the lowest taxes for us. Thank you.
You can elect to either file “married filing separately” or “married filing jointly.”
My husband of 38 years died two months after moving into a new home that we had built. I think I can sell the home for 100k more than we paid. It has been 16 months since we closed and moved into the home. Am I exempt from the capital gains tax that I would normally have to pay when selling less than the two years required to live in residence..? I live in Texas and plan to downsize when I move.
I’m so sorry for your loss. The tax basis for his half of the property is the value at the date of his death. And if you are in a community property state, your half may also have that increased tax basis. In addition you may be able to prorate the $250,000 exclusion under an exception to the 2-year rule because of unforeseen circumstances.
my husband passed away 2016. We have lived in this home for 45yrs, purchased it for around $80k. Now will be purchasing a smaller home with a mortgage in a retirement community for around $300.00 and then sell this home with asking price of $499,900 (cannot sell it first in case I am left without a home to live in prior to finding the smaller home as they don’t come on the market often). I hope to walk away with $450.00. My income is around 50K. What will this cost me in taxes 🙁
Your husband’s half of the home received a stepped up basis to the value on the date of his death. If you live in a community property state and the home was held as community property, then your half would also receive a stepped up basis. And you can exclude up to $250,000 of gain on the sale of the residence. So it is likely you won’t owe much at all in taxes.
If I have a capital gain on sale of a home in which I lived two of the last five years, does this amount get added to my annual income that determines which capital gains tax bracket I fall into? Is the total amount added in, or just the part that is not exempt from capital gains tax?
You can exclude up to $250,000 of gain on the sale of a home that you owned and occupied for two of the five years prior to sale. If the gain exceeds that, the excess is included as capital gains on your tax return. Your rate of capital gains tax depends on your total income shown on your tax return — for most people capital gains are taxed at 15%, but if your income is considerable, your tax rate could be higher.
How do you determine what is your rate of Capital Gain Tax . My husband died in 2016 and I moved to Arizona in August 2017 to be near my daughter. I owned a townhouse and it had been rented for several years but in order to have money to purchase a place in Arizona, I had to sell the townhouse. Provisions were made in my husband trust for me to live in the residence where he and I lived but had stipulations that I could not remarry or co-habitate with another man. Also, if I was gone from this residence for more than 6 months, it would revert to his son who lived right next door. I made the decision to move to Arizona to be near my daughter and her family because of my age (79) and health reasons. This townhouse I sold was never in my husbands name. I owned it at the time we married in 2004.. He enjoyed the rent money this house generated for all those years just as I did. It was a supplement to our income. I tell you all this because it just seems unfair when this townhome was the only home I had ever owned and now I don’t have the exclusion rights from Capital Gains Tax. If you can give me any advice, it would be really appreciated.
In order to claim the $250,000 capital gains exclusion, the home must have been your principal residence for 2 of the 5 years prior to sale.