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Capital gains are a critical concept in the world of real estate, yet many homeowners and real estate investors don’t fully understand how they work or how they’re taxed. Whether you’re selling your home or flipping investment properties, understanding capital gains can help you make smarter financial decisions and avoid costly surprises. This guide will break down what capital gains are, how they’re taxed, and what exemptions and strategies you can use to minimize your tax liability.
Capital gains refer to the profit earned from selling a capital asset—such as real estate—for more than its original purchase price. The difference between the sale price and the asset’s cost basis (including purchase price and improvements) is your capital gain.
Two types of capital gains exist:
| Short-Term Capital Gains | Profits from property held for up to one year. These are taxed at your ordinary income tax rate. |
| Long-Term Capital Gains | Profits from property held for at least one year. These are taxed at lower tax rates, depending on your income bracket. |
Why this matters: Two sales with the same profit can result in very different tax bills, depending on how long you held the property and whether you qualify for exclusions or special rules.
Selling your home can trigger a capital gains tax, but many homeowners can qualify for a home sale exclusion, which may be used only once every two years.
Under IRS rules (Section 121), you can exclude up to:
To qualify, you must meet ownership and use tests:
To determine your taxable gain, use the following formula:
| Capital Gain = Sale Price − (Purchase Price + Improvements + Selling Costs) |
Let’s say you bought a home in 2015 for $300,000 and sold it in 2025 for $600,000. During your ownership, you spent $50,000 on renovations and paid $30,000 in selling costs.
Assuming you’re single and meet the IRS ownership and use tests, you qualify for the $250,000 exclusion.
Result: You owe no capital gains tax because your gain is below the exclusion threshold.
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When You Might Owe Taxes
You’ll owe capital gains tax only on the amount that exceeds the exclusion limit. For example, if you’re married and make $600,000 in profit from selling your home, you’ll pay tax on $100,000 (based on the maximum $500,000 home sale exclusion amount). |
Real estate investors face different rules and opportunities when it comes to capital gains.
Selling rental or commercial property typically triggers capital gains tax. If the property was held for more than a year, it qualifies for long-term capital gains rates.
However, investors must also account for depreciation recapture, a tax rule that kicks in when you sell a property for more than its depreciated value. In simple terms, if you claimed tax deductions over the years, then sold the home for a profit, the IRS will “recapture” those deductions by taxing part of your gain as regular income instead of a lower capital gains rate.
Depreciation recapture is taxed at a maximum rate of 25%.
A powerful tool for investors is the 1031 exchange, which lets you defer capital gains tax by reinvesting the proceeds of the sale into a “like-kind” property. This strategy is commonly used to grow real estate portfolios without triggering immediate tax liability.
Capital gains tax is reported and paid as part of your annual federal tax return using Form 8949 and Schedule D.
If you receive a Form 1099-S from a real estate transaction, you must report the sale—even if the gain is excluded.
Whether you’re a homeowner or investor, here are smart ways to reduce your capital gains tax liability:
Most homeowners don’t pay capital gains tax thanks to the exclusion rule.
Capital gains are taxed separately and don’t affect your ordinary income bracket directly.
You only pay tax on the profit, after subtracting your cost basis and any exclusions.
Do I owe capital gains tax when I sell my primary home?
Maybe not. If you pass the ownership and use tests, you may exclude up to $250,000 ($500,000 if married and filing jointly) of gain.
How long do I have to live in a home to qualify for the exclusion?
You must live in the home at least 2 of the last 5 years before sale, and you can’t have used the exclusion in the prior 2 years.
Are closing costs deductible?
Selling costs reduce the amount realized, which may reduce taxable gain.
How are short-term vs. long-term capital gains taxed?
Short-term capital gains are taxed at ordinary income tax rates. Long-term gains are taxed at lower, preferential rates.
Can I offset capital gains with capital losses?
Yes. Losses offset gains. Excess losses can offset up to $3,000 of ordinary income per year, with the remainder carried forward.
What is a 1031 exchange?
A 1031 exchange is a way to defer taxes by reinvesting proceeds from the sale of investment real estate into like-kind real estate, following strict rules and timelines.
Capital gains can be a powerful source of wealth, but they may come with certain tax implications. For homeowners, the IRS offers generous exclusions that can shield most or all of your profit from taxes. For investors, strategic planning—like timing your sales or using a 1031 exchange—can help you keep more of your gains. Understanding the rules and applying smart strategies ensures that you maximize your financial outcome while staying compliant.
Are you ready to buy a home and are ready to apply for a mortgage? If so, Sammamish Mortgage can help. We are a local mortgage company from Bellevue, Washington serving the entire state, as well as Oregon, Idaho, Colorado, and California. We offer many mortgage programs to buyers all over the Pacific Northwest and have been doing so since 1992. Contact us today with any questions you have about mortgages, or visit our website to get an instant rate quote.
Whether you’re buying a home or ready to refinance, our professionals can help.
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