Capital gain is simply a term used to describe the appreciation on a capital asset. A capital asset is almost any tangible, durable property that is intended to be held for a long period of time. A house falls within this definition.
The issue that concerns most people in regard to capital gain is capital gain tax. Both the federal treasury department and state departments of revenue impose a tax on the realization of capital gain. The tax is typically a percentage of the appreciation, the gain, on the value of the asset. The percentage increases depending on the income tax bracket of the taxpayer and the amount of time the taxpayer held the asset. The tax rate ranges from 5% to 28% and is generally higher for an asset held for less than a year.
Capital gain taxes are only owed when the capital gain is both recognized and realized. Recognition means exactly what it sounds like, that the I.R.S. recognizes the existence of the gain. Realization of the gain occurs when a capital asset is disposed of by sale. After the sale, the appropriate tax rate is applied to the gain or the difference between the fair market value of the house (at the time of sale) and the seller’s purchase price (known as the basis).
Let’s go through an example to put it all together. Say you purchased a house for a $100,000.00. You now own a capital asset and have $100,000.00 basis in it. After five years of owning the house, you learn that it is worth $150,000.00. You have $50,000.00 in recognized, but unrealized capital gain. Notice that the amount of gain is equal to the amount of the fair market value minus the amount you paid for the house (our basis). You are not taxed on the gain at this point because, though it is recognized (the default position for any taxable event), it is not realized. Let’s say, five years later, the house is worth $200,000.00 and you sell it to a nice young couple who just moved here from Topeka. At this point, you have $100,000.00 in recognized, realized capital gain on which you owe long term capital gains tax. If you were taxed at the rate of 15%, you’d only be taking home $85,000.00 of that gain because $15,000.00 of it would go to the I.R.S. (For this example we’ll ignore state capital gains taxes which usually just piggyback on the federal taxes).
Just to put a finer point on things, what would happen if you had, let’s say in a property settlement, sold your house to your soon to be ex-husband instead of that couple from Kansas. You would have realized gain, but you still would not be taxed because you would not have recognized gain since the I.R.S. does not generally recognize financial transactions between spouses, considering them one financial unit (this is why spouses must elect to file their income taxes separately). Remember, that to owe capital gains tax, the capital gain must be both realized and recognized.