Historically, income from selling a rental property, a primary residence, and other capital assets has been taxed at a lower rate than other income. The proceeds from a sale of a capital asset are subject to tax, but the tax calculation is different than that applied to ordinary income.
Before getting further into the subject, let’s first ensure an understanding of the definitions for these terms. Ordinary income, subject to federal income tax, can be earned or unearned. Examples of ordinary income are wages, tips, account interest, unemployment compensation, and the proceeds generated from the sale of a capital asset owned over a short term.
A short-term hold period is defined as one year or less. The IRS recognizes these categories as ordinary income and is subject to federal income tax.
However, the proceeds from the sale of a capital asset held over a long term, that being more than one year, are subject to a capital gains tax. The calculation of this tax is not linear like that of the federal income tax. There are specific thresholds used to determine the rate of this tax. These thresholds are illustrated later in this article.
The policymakers, the creators of the tax code, have enacted these thresholds and rates to motivate investment. Investment into rental properties and other capital assets is recognized as a stimulant to the economy, and investment is encouraged.
This article aims to explain the basic rules applied to the calculation of the tax on capital gains. The contents of this article can be used as a guide to understanding the definitions, the tax framework, and the rate to apply to your gain.
Capital Gains
The simple definition of capital gains is the profit made from the sale of a capital asset held for either investment or for personal use. For the purpose of this article, the examples of capital assets are real estate held for rent to third parties and a primary residence.
Investors in residential rental properties need to be careful. If a residential unit’s purchase and flip are made too often during a year, then the definition of a capital asset will not hold. The property could be classified as inventory, and the sale of inventory items is not defined as a capital gain. The sale of any inventory item is taxed as ordinary income.
When are the Gains Taxed?
The gains, or the profit, from the sale of a capital asset, are taxed when the gain is realized. A gain is realized if the sale proceeds are greater than the purchase price. If the capital asset remains under your ownership, capital gains tax will not apply. Appreciation “realized” by market conditions or the pledging of the property for a loan will not trigger the capital gains tax.
There are other events that may trigger a gain, as realized, but these are beyond the scope of this article.
Tax Rates for Capital Gains
When a capital asset is owned for more than one year (one year plus one day), the realized gains will be taxed at a lower rate than ordinary income.The gain realized by the sale of depreciable capital property, also known as depreciation recapture will be reported and taxed as ordinary income.
The IRS “recaptures” the whole depreciation expense that was used to lower taxable net income and taxes it at the investor’s regular income tax rate, up to a maximum tax rate of 25%.The remaining excess profit is taxed as a capital gain. There are three brackets relative to the taxes assessed on capital gains: 0%, 15%, and 20%. The rate, or the bracket, will depend upon your taxable income and filing status.
For 2022, the brackets, and the taxable income thresholds are illustrated below:
0% 15%
Single $41,675 Single $459,750
Married/Joint $83,350 Married/Joint $517,200
H of H $55.800 H of H $488,500
Married/Single $41,675 Married/Single $459,750
If your taxable income is over the 15% threshold for your filing status, your tax bracket is 20%.
With the current income thresholds and the tax brackets in place, an investor may want to consider selling capital assets over a span of years to take advantage of the 0% and the 15% brackets.
In past years before the revision of the tax code, capital gains tax was avoided by exchanging one capital asset for another. The closing added another expense layer for consultants, attorneys, and third-party reports for this intermediary tier. These transactions were technical and expensive. The expenses relative to a 1041 exchange were justified when the capital gains tax rate was a flat 35%.
Today, given the high-income thresholds and low rates, investors opt to pay the tax and retain access to and use the net sales proceeds. The expenses relative to an asset exchange are more than the taxes due.
As illustrated above, the effective tax rate on capital gains is based upon taxable income and filing status, not on the amount of the gain.
Principal Residence Exclusion
Your primary residence is a capital asset. The gain may be taxable if you sell your house and make a profit. However, by virtue of the Tax Relief Act of 1997, many homeowners are excluded from the tax under certain conditions. This Act introduced taxable income thresholds and the flat tax rate was abolished. Over the years, the income levels have increased, and the applicable rates have decreased to those shown above.
If you are a single filer, the first $250,000 of realized gain from the sale of your home is excluded from the capital gains tax. If you file as a married couple filing joint returns, the first $500,000 of realized gain from the sale will be excluded. Note that the exclusion is based on the gain, not the sale price. The gain is calculated as any other gain: the difference between the purchase and the selling prices.
If capital improvements were made to the home over the course of ownership, then the costs of these improvements are added to the original purchase price to increase your investment in the home. This increase in basis will correspondingly decrease your realized gain.
However, for the exclusion to apply, the home must have been owned for at least two years and used as your primary residence.
Therefore, this exclusion is allowed once every two years.
An example of this exclusion follows:
A Single filer with a taxable income of $70,000 paid $100,000 for a home three years ago.
The owner lived in the home as a primary residence throughout the ownership period.
A bedroom was added to the home for $20,000, and the roof was replaced for $15,000.
The sales price of the home was $300,000.
Basis in the home:
Original Purchase Price $100,000
Value of Capital Improvements 35,000
Adjusted Basis $135,000
Sales Price $300,000
Less Adjusted Basis (135,000)
Realized Gain $165,000
Amount subject to tax $0
In the example above, the realized gain of $165,000 is within the $250,000 exclusion for Single filers; therefore, no capital gains tax is owed. The amount of taxable income is not a factor in this instance.
As with any IRS rule, and the tax code itself, there are exceptions, adjustments, and exclusions that are beyond the content and objective of this article.
This writing aims to give an overview of the definition of capital gains and the determination of the tax bracket to apply to your gain.
It is our hope these goals are accomplished.
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