Selling Real Estate? Here’s What You Need to Know About Taxes Before You Close

For many people, real estate is the largest investment they’ll ever make. Whether you are selling your home, a vacation property, or a rental you’ve held for years, the sale means an influx of cash, but it can also bring a tax bill. Understanding how the IRS looks at real estate sales can help you plan ahead and avoid surprise tax bills months after the closing.

The Primary Residence Exclusion: A Big Advantage for Homeowners

One of the most favorable tax provisions available to individuals is the primary residence exclusion. If you’ve owned and lived in your home for at least two of the last five years, you may be able to exclude up to $250,000 of gain from tax if filing single, or $500,000 if married filing jointly.

This exclusion can make a big difference. For example, if you purchased your home for $300,000 and later sold it for $600,000, a married couple could potentially exclude the entire $300,000 gain from taxes. Without this exclusion, a large portion of that gain could be subject to capital gains tax. Given the continued increase in home prices over the past 5 years, this is a common situation for many homeowners that have significant equity built up in their home.

It’s worth noting, however, that the exclusion does not apply to rental or investment properties. If you’ve converted a former home into a rental, or vice versa, the rules can get more complex and may require a careful review with your tax advisor.

Short-Term vs. Long-Term Capital Gains

If you don’t qualify for the home sale exclusion or if you’re selling property that’s not your primary residence, your profit will generally be subject to capital gains tax. The key factor here is how long you owned the property:

• Short-Term Gains: If you owned the property for one year or less, the profit is taxed at your ordinary income tax rate, which can be as high as 37% (Federal only). It doesn’t get much worse from a tax perspective than large Short-Term Gains, so we recommend avoiding this strategy unless absolutely necessary.
• Long-Term Gains: If you held the property for more than one year, your profit qualifies for the lower long-term capital gains rates, which range from 0% to 20% Federally, depending on your income level. For most people, this results in a significantly lower tax bill compared to short-term treatment.

The difference between short- and long-term treatment can easily be tens of thousands of dollars. For this reason, many investors choose to hold property at least long enough to qualify for the long-term rates.

Depreciation Recapture: The Hidden Tax on Rentals

For rental or investment properties, there’s an additional tax layer to consider: depreciation recapture. Over the years, you may have claimed depreciation deductions to offset rental income. While those deductions reduce your taxable income during ownership, the IRS requires you to “recapture” that benefit when you sell.

Here’s how it works:

• Let’s say you purchased a rental property for $400,000 (excluding land value).
• Over several years, you claimed $100,000 in depreciation deductions.
• When you sell the property, the IRS assumes your adjusted cost basis is $300,000 (original cost minus depreciation).

If you sell the property for $500,000, you’ll have a $200,000 gain. Of that, $100,000 will be taxed as depreciation recapture at a maximum rate of 25% (Federally), while the remaining $100,000 will be taxed at capital gains rates.

This recapture rule often catches investors off guard. While depreciation is a valuable deduction during ownership, it’s important to remember that it carries a tax cost later when you exit the property. Think of it as a “temporary” deduction rather than a true reduction in your tax.

Case Study: Two Different Outcomes

Let’s look at two common scenarios to see how the rules play out in practice:

• Homeowner Sale: Jane and Mark bought their primary residence for $350,000 and lived there for eight years. They recently sold the home for $650,000. As a married couple, they qualify for the $500,000 exclusion, which means their entire $300,000 gain is tax-free. Their net proceeds go directly into their pocket.
• Rental Property Sale: Mike purchased a rental property for $400,000 and claimed $80,000 in depreciation deductions over the years. When he sold the property for $550,000, his adjusted basis was $320,000, creating a total gain of $230,000. Of that, $80,000 was subject to depreciation recapture at 25%, while the remaining $150,000 was taxed at long-term capital gains rates. Even though both Jane and Mark, and Mike, sold real estate, their tax outcomes were dramatically different.

This simple comparison highlights why planning is so important before you sell.

Additional Considerations: State Taxes and Net Investment Income Tax

Beyond federal taxes, most states also impose their own income tax on real estate gains. Depending on where you live, this can add another 5% to 13% (or more, sorry CA residents…) to your tax bill.

For higher-income taxpayers, the 3.8% Net Investment Income Tax (NIIT) may also apply. This surtax affects individuals with modified adjusted gross income above $200,000 (single) or $250,000 (married filing jointly) and applies to capital gains and other investment income.

Taken together, these layers of tax will significantly erode your net proceeds from a sale.

Planning Ahead: Strategies to Reduce the Tax Burden

The good news is that with advance planning, there are strategies to help minimize taxes on a real estate sale:

• Time your sale carefully: Waiting just long enough to qualify for long-term rates can save significant dollars.
• Leverage the home sale exclusion: Make sure you meet the residency requirements before selling your primary residence.
• 1031 exchanges: For investment property, a like-kind exchange may allow you to defer taxes by reinvesting the proceeds in another property.
• Charitable planning: Donating a portion of appreciated property to charity can provide both a deduction and a way to reduce taxable gain.
• State-specific strategies: Because state tax treatment varies, working with an advisor familiar with your state rules is essential.

Each situation is unique, so what works best for one taxpayer may not work for another.

Final Thoughts

Selling real estate is can be both a financial and emotional decision, but it’s also a tax decision. The way you structure your sale, how long you’ve owned the property, and whether you’ve used it as a residence or rental all have significant tax consequences.

Before you list the property, it’s smart to meet with your CPA or financial advisor to map out the potential tax impact and explore strategies to keep more of your net proceeds in your pocket.

At Southcoast Financial Partners, we help clients plan ahead for these important moments so they can move forward with confidence and knowledge. If you’re considering selling an investment property, let’s talk about the right strategy for your situation and plan ahead together.