Appreciation, and the profit that comes with it, is surely a major benefit of home ownership. But that profit does not come without a cost. You can’t hide from the tax collector, and sooner or later he or she will come looking for you to extract that cost, usually as a capital gain.
Active Versus Passive Income
The money we earn as income is divided into two categories: active and passive. Active income includes wages, tips, salary, and income from businesses in which we have material participation. Passive income is earnings an individual derives from investments, such as rental property, stocks, bonds, limited partnerships, or other enterprises in which they are not actively involved.
Put another way: money we earn while we are working is viewed differently than income we earn while we are sleeping, and they are treated differently for tax purposes. The IRS applies a different set of rates for passive and active income. Active income (the money from your job) is taxed at a higher rate than passive income (the money from your investments). One further distinction is whether that passive income from your investments is a result of a profit from ongoing business operations — like annual profit from a real estate investment or dividends on stocks — or a result of the sale of the investment at a profit over the original cost of the investment. That second case is known as a capital gain.
What Is a Capital Gain?
A capital gain is an increase in the value of a capital asset — like an investment or real estate — that results in a higher worth than the price you originally paid for it. The gain is realized when the asset is sold. A capital gain may be short term, defined as less than one year; or long term, defined as more than one year. The gain must be claimed on income taxes and is a taxable event. Stated simply, a capital gain is the profit from the sale of real estate or another investment. Under the tax act passed in 2017, there is no capital gains tax on the sale of investments for individuals or married couples in the 10 percent and 15 percent tax brackets. Those in the 25-35 percent tax brackets are subject to a capital gains rate of 15 percent on their taxable basis. If you purchase an investment — stocks or real estate, for instance — for $100,000, and then sell five years later for $200,000, you have a profit of $100,000 — and at 15 percent, a balance of $15,000 due the IRS.
The U.S government has long used the tax code as a tool to increase both the incidence and viability of homeownership. Owning a home is often considered to be the cornerstone of ‘the American Dream.’ For that reason, capital gains resulting from the sale of a primary residence have been treated somewhat differently — and preferentially — then the gains from other passive investments, such as the sale of stock, bonds or investment real estate.