Tax Treatment of Gains on Different Types of Residential Real Estate

The tax consequences related to the sale of a residential property depend largely on the characterization of the property. For example, the sale of one’s principal residence is treated differently than other types of residential real estate. Likewise, investment properties or vacation homes held for more than a year are treated more favorably than such properties held for less than a year. Whether you are considering entering the rental market, flipping homes, or selling your principal residence, it is important to understand how each will be taxed when it is time to sell.

Primary Residence

When you sell your principal residence, you may be able to exclude from taxation up to $250,000 in gains if you are single, or $500,000 if you are married, so long as you have both owned and lived in the property as your principal residence for two out of the prior five years. This is not a one-time exclusion. It can be used over and over on different properties, so long as the two-year requirements are met each time. However, you can only have one principal residence at a time and any gains over the applicable exclusion amount will be taxed at capital gains rates. If you do not meet the two-year test for both use and ownership, the entire gain from the sale of your primary residence will be taxed at capital gains rates. It is important to note, though, that there are some exceptions to this general rule where you may qualify for a partial exclusion even if you do not meet the two-year tests.

Residential Rental Property

Rental properties add another wrinkle that differentiates them from other types of residential properties. An owner is entitled to depreciate the value of the property on his or her income taxes over the course of 27 ½ years. For example, if you buy a rental property for $275,000, you can depreciate the property at $10,000 per year for 27 ½ years such that the tax basis becomes $0. If you then sell the property for $400,000 after having depreciated the entire value of the property, you will be required to pay the capital gains rate on the $120,000 gain realized from the sale of the property and also a maximum of 25 percent (an attractive rate to individuals in higher tax brackets) on the $275,000 that was depreciated over the years.

Other Residential Property: Anything from the Vacation Home to the Fixer Upper

For all other residential property that is not your primary residence— whether it is a vacation home or a fixer upper—if you have owned the property for more than a year, you must pay tax on any profit at the capital gains rate. However, if you have not owned the property for more than a year at the time of the sale, the profit is taxed at ordinary rates.

Although taxes may not be the decisive factor when selling a piece of property, they are an important consideration since they could significantly impact the amount of money you actually collect from a particular transaction. Therefore, when making decisions to buy or sell real estate, an attorney or tax advisor can provide guidance about any timing issues and the associated tax burdens.

Tamlyn Frederick