Capital Gains Tax on Real Estate: What Is It? How Does It Work? And How To Avoid Capital Gains Tax (2021 Edition)

Dollar bill on a white table in front of a white brick wall

The capital gains tax system can be complicated.

But, if you understand the basic concepts the system is built on, the rest falls into place.

Throughout this guide, we’ll help you understand Texas capital gains tax and how to avoid it.

We’ll cover the following step-by-step, but feel free to jump ahead to any section:

What Are Capital Gains?

The definition of capital gains is as follows: “An increase in a capital asset’s value and is considered to be realized when the asset is sold.”

Let’s say you purchase a home for $300,000. Several years later, after a few notable repairs and a renovation, you sell that same home for $425,000. By selling the home for that price, you earned $125,000 more than the amount you initially paid for the home.

That’s what capital gains are; selling a property or investment and making more money than you originally spent to acquire the property/investment.

Yes/no decision chart showing that if a capital asset is sold for a profit, it is considered a capital gain. If it is sold for a loss, it is considered a capital loss

Anytime you sell a home for more than you initially paid, you will have earned capital gains.

Anytime you earn capital gains, you will need to pay capital gain taxes.

Capital Assets

The same basic concept applies to anything that is considered a “capital asset.”

Some of the most common capital assets include real estate, stocks, and bonds. 

Therefore, if you sell one of those assets and earn capital gains, you must pay federal taxes on those capital gains.

Types of Capital Gains

There are two types of capital gains. They are:

Both types of capital gains are dependent on how long you owned the security (i.e., house) but are taxed in different ways.

Short-Term Capital Gains Tax

The first type of capital gains is known as “short-term capital gains.” 

Short-term capital gains are, in the context of selling real estate, the profits you make after selling a home you’ve owned for less than one year.

If you buy a home for $240,000, sell it six months later for $280,000, you’ve just earned $40,000 in short-term capital gains.

Selling house after one year or less means short-term capital gains tax is due on the profit

Every little bit of income that falls into the short-term capital gain you just earned is considered regular taxable income. All of this regular taxable income is subject to the taxation rules of your tax bracket.

Anytime you earn short-term capital gains, you will need to pay income tax on your earned money.

Long-Term Capital Gains Tax

The second type of capital gains is known as “long-term capital gains.”

Long-term capital gains are the profits you make after owning a home for more than one year.

If you purchase a home for $300,000 and sell it eight years later for $500,000, you’ve just earned $200,000 in long-term capital gains.

Selling house after more than one year means long-term capital gains tax is due on the profit

Tax rates for long-term capital gains are dependent on your:

Capital Loss

If you purchase a home for $250,000 and sell it for $125,000, you’ve earned a capital loss rather than a capital gain.

You are not required to pay any capital gains tax since you’ve sold a capital asset at a capital loss.

Bar graph showing purchase price is higher than sales price to demonstrate capital loss

You can often use the capital loss to offset any capital gains or any regular income tax in this situation.

The same concept applies to real estate and other capital assets, such as stocks and bonds.

Realized VS. Unrealized Gains

Realized gains occur when a capital asset increases in value and is sold. Unrealized gains occur when an asset increases in value but a sale does not occur.

Short-term capital gains and long-term capital gains fall into two categories:

Realized gains are capital gains that you’ve earned from a completed sale.

Let’s say you purchase a home for $100,000 and then sell that same home for $300,000.

As soon as you complete that sale, you’ve just earned $200,000 worth of capital gains. All of that money is subject to capital gains tax.

Realized gain means there must have been a completed sale to qualify for capital gains tax

But, let’s say that you still own that home. Over the years, it has grown to be worth $300,000 due to fluctuations in the housing market, and you aren’t selling it.

Since you aren’t selling the home, even though you could do so and earn significant capital gains, your capital gains of $200,000 are “unrealized gains.” The capital gains are unrealized since there is no tangible profit from a completed sale.

Unrealized gain is when no profit is made through a sale so no capital gains tax is due

Unrealized gains are, of course, non-taxable since there is no tangible profit.

The taxes that come with capital gains are only applicable to realized gains from a completed sale.

Capital Gains Tax In Texas

Texas’s capital gains tax rate is 0% because Texas, as a state, does not tax capital gains. Capital gains are taxed at the federal level at either 0%, 15%, or 20%. Your capital gains tax rate is determined by your filing status, income, and exemption status.

The reason for this is because all real estate you own is considered an “investment property.” Investment properties are taxed at the federal level.

You can earn significant capital gains on the sale of a property, and some may go to the Federal Government. However, you will not need to pay any state capital gains tax on top of that, as Texas does not tax state-earned income.

Federal Capital Gains Tax Rates for 2021

The following federal capital gains tax rates are meant for people who earn long-term capital gains. 

For those who earn short-term capital gains, the capital gains tax rate is irrelevant. All short-term capital gains will be added to your regular income and taxed using the appropriate income tax bracket.

For those who earn long-term capital gains off of real estate assets that they’ve owned for more than one year, the tax rates outlined below are indicative of what you should expect to pay.

0% Rate

Single filers with an income of up to $40,400 per year, your capital gains will be taxed at 0%.

Taxpayers who file as head of household, if you earn no more than $54,100 per year, your capital gains will be taxed at 0%.

Married taxpayers who file jointly and earn no more than $80,800 per year, your capital gains will be taxed at 0%.

Married taxpayers who file separately and earn no more than $40,400 per year, your capital gains will be taxed at 0%.

Displays the max income for each filing category in order to qualify for the zero percent capital gains rate

If you fall into any one of those filing categories and earn less than the amount specified, you won’t need to pay any taxes on your long-term capital gains.

15% Rate

Single filers with an income of anywhere from $40,401 to $445,850 per year, your capital gains will be taxed at 15%.

Taxpayers who file as head of household, if you earn anywhere from $54,101 to $473,750 per year, your capital gains will be taxed at 15%.

Married taxpayers who file jointly while earning anywhere from $80,801 to $501,600, your capital gains will be taxed at 15%.

Married taxpayers who file separately and earn anywhere from $40,401 to $250,800, your capital gains will be taxed at 15%.

Displays the max income for each filing category in order to qualify for the fifteen percent capital gains tax rate

If you fall into any of those categories, the long-term capital gains you earn on the sale of your home will be taxed at 15%.

20% Rate

Single filers who earn more than $445,851 per year, your capital gains will be taxed at 20%.

Taxpayers who file as head of household, if you earn more than $473,751 per year, your capital gains will be taxed at 20%.

Married taxpayers who file jointly and earn over $501,601 per year, your capital gains will be taxed at 20%.

Married taxpayers who file separately and earn over $250,801 per year, your capital gains will be taxed at 20%.

Two column Income requirements chart to qualify for twenty percent capital gains tax rate

If you fall into any of those categories, 20% of the long-term capital gains you earn from selling a home must go to the IRS.

How to Avoid Capital Gains Tax

There are multiple ways to avoid capital gains tax:

If you earn less than the amount of money specified in the 0% capital gains tax bracket, you will not need to pay any capital gains taxes.

OR

Meet the following criteria:

  • The home you sold must be your primary residence.
  • Have owned the home for at least two years.
  • If you’ve owned the home for longer, you must have lived in the home for at least two years within the most recent five-year period.
  • You must not have claimed the capital gains tax exemption within the past two years on another piece of property.

The final key piece of criteria is dependent on your filing status:

If you are a single-filer, you can earn as much as $250,000 in capital gains from the sale of your home. But, if you earn more than $250,000 from the sale, you will need to pay capital gains taxes.

If you file jointly, you can earn as much as $500,000 in capital gains from the sale of your home. But, as mentioned above, if you earn more than $500,000 in capital gains, you will need to pay capital gains taxes.

Examples: Capital Gains Tax on Real Estate

To further highlight the nature of capital gains tax, three examples are outlined below.

Example 1: Meeting the IRS’ Criteria For a Capital Gains Tax Exemption

A married couple purchases a beautiful Dallas home for $300,000.

For the next five years, the married couple lives in the home.

Soon after the five-year mark, the married couple decides to sell the home.

Due to fluctuations in the housing market and a few notable repairs, they sell the home for $450,000.

From the sale of their home, the married couple earns $150,000 in capital gains.

Since this married couple owned the home for over five years, lived in it for more than two years during that period, and have not claimed the capital gains tax exemption within the most recent two-year period, they pay no taxes on their long-term capital gains up to $500,000.

Example 2: Paying the 20% Rate

A single man purchases a small Dallas home for $145,000.

Just over one year later, the man chooses to sell the home.

The man sells the home for $185,000, earning $40,000 in capital gains.

Since the man hasn’t owned the home for at least two years, he is not exempt from paying capital gains tax.

Furthermore, the man earns more than $445,851 per year, meaning he’ll need to pay a 20% rate on his capital gains.

After the sale, the man pays $8,000 to the IRS. He keeps the remaining $32,000 of his capital gains.

Example 3: Paying the 0% Rate

A man, who earns $40,000 per year, files as the head of his household, buys a home for $250,000.

Just over one year later, the man sells the home for $275,000.

Even though the man just earned $25,000 in capital gains, none of that is going to go to the IRS.

The reason for this is because the man does not earn more than $54,100 per year.

Conclusion

Even though capital gains can be tricky, it is remarkably easy to be exempt from paying capital gains tax.

Just make sure you’ve done the following:

  1. Lived in your home for at least two years.
  2. Haven’t claimed a capital gains tax exemption within the past two years.
  3. Depending on your filing status, earn less than $250,000/$500,000 in profit on the sale of your house.

If you’re ready to sell your troublesome house, these exemptions are a great way to put more money back in your pocket. Contact us today to get your no-obligation offer.

We buy houses in:

We’ll visit your property, give you a fantastic cash offer, and purchase your home as soon as possible. 

The best part is, assuming you meet the requirements outlined above, you won’t need to give a penny of your capital gains to the IRS!

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