Arizona Capital Gains Tax on Home Sale: Exclusion, Rate, and Recapture

Most people selling a primary home in Arizona pay no state tax on the profit, and many pay no federal tax either. The Arizona capital gains tax on a home sale works off your federal return: the IRS lets single filers exclude up to $250,000 of gain and joint filers up to $500,000, and anything excluded federally never reaches your Arizona return. Whatever gain remains gets a 25% subtraction under Arizona law, and the leftover is taxed at the state’s flat 2.5% rate. On a $350,000 profit for a single filer, that works out to $1,875 in Arizona tax.

The Federal Exclusion That Usually Wipes Out the Gain

Internal Revenue Code Section 121 lets you exclude up to $250,000 of gain from selling your primary residence, or up to $500,000 if you’re married filing jointly and at least one spouse owned the home while both spouses used it as a primary residence for at least two of the five years before the sale.¹ The ownership and use periods don’t have to overlap, and they don’t have to be consecutive.

Arizona starts its income tax calculation from your federal adjusted gross income, so any gain excluded under Section 121 is already gone by the time you fill out the state return.² The state inherits the federal exclusion automatically.

The exclusion only covers a primary residence. Investment properties, vacation homes, and rentals that were never your home don’t qualify, and the full gain on those sales flows through to both your federal and Arizona returns.

One trap: even when the exclusion covers your whole gain, the closing agent may send you a Form 1099-S reporting the sale proceeds. If you receive one, the IRS expects you to file Form 8949 and Schedule D anyway. If no 1099-S was issued and the gain is fully excludable, you can skip federal reporting.³

Partial Exclusion If You Sold Before Two Years

Selling before you’ve hit the two-year mark doesn’t automatically disqualify you. If you sold because of a job relocation, a health condition, or certain unforeseen circumstances, you can claim a prorated share of the exclusion.

The IRS treats a move as job-related if your new workplace is at least 50 miles farther from the home than your old one was. Health moves cover diagnosis or treatment for you, a spouse, or a family member. Other qualifying events include divorce, multiple births from the same pregnancy, involuntary conversion of the home, and natural disasters or acts of terrorism.³

To find the partial amount, divide the months you lived in the home by 24 and multiply by $250,000 or $500,000. Fourteen months of residence before a qualifying job transfer would let a single filer exclude about $145,833.³

Figuring the Gain in the First Place

Your gain isn’t just sale price minus purchase price. The IRS works from your adjusted basis, which is usually higher than what you originally paid.

Basis, Improvements, and Selling Costs

Start with the purchase price from your original settlement statement. Add capital improvements, which are projects that add value, extend the home’s useful life, or adapt it to a new purpose. A new roof, a kitchen remodel, and a swimming pool all count; repainting walls or fixing a faucet does not.⁴

Certain purchase closing costs also raise your basis, including title insurance, survey fees, and transfer taxes. On the sale side, real estate commissions, title and escrow fees, and transfer taxes reduce the amount realized, which lowers your taxable gain.⁵ Hold onto receipts, contractor invoices, and both closing disclosures. They matter at audit and tend to disappear during the years between buying and selling.

Inherited Homes Get a Stepped-Up Basis

If you inherited the home, your basis is typically its fair market value on the date the previous owner died, not what they paid for it. This stepped-up basis under IRC Section 1014 can erase most or all of the taxable gain.⁶ If the estate filed an estate tax return and the executor elected an alternate valuation date six months after death, that becomes your basis instead.

A parent who bought a home for $120,000 that was worth $450,000 at death leaves you with a $450,000 basis. Sell for $475,000 and the gain is $25,000, not $355,000. An appraisal performed near the date of death is the strongest documentation.

Arizona’s 25% Long-Term Capital Gains Subtraction

Arizona offers a subtraction most states don’t. Under ARS 43-1022, you can subtract 25% of your net long-term capital gain from your Arizona gross income. The property must have been held more than one year, and for tax years through 2025, it must have been acquired after December 31, 2011.⁷

Starting with the 2026 tax year, new legislation expands the subtraction to all assets regardless of when they were acquired.⁸ That’s a real change for anyone selling a home bought before 2012.

The subtraction applies to whatever long-term gain remains after the Section 121 exclusion. Say a single filer clears $350,000 in profit on a primary home. The first $250,000 is excluded federally and never shows up on the Arizona return. Of the remaining $100,000, the state subtracts $25,000, leaving $75,000 subject to Arizona income tax.

For a home received as a gift or inheritance, Arizona uses the original owner’s acquisition date. If that date can’t be verified, the subtraction is denied.⁷

The 2.5% Flat Rate

Arizona replaced its graduated brackets with a flat 2.5% income tax rate beginning in 2023.⁹ Capital gains are treated like wages for state purposes, so the flat rate applies to your home-sale profit after the federal exclusion and the 25% subtraction.¹⁰ On that $75,000 of Arizona-taxable gain from the example above, the state tax is $1,875.

What the IRS Will Still Take

Arizona’s slice is usually the smaller one. The federal government taxes long-term capital gains at 0%, 15%, or 20% based on total taxable income. For 2026, single filers pay 0% on gains up to $49,450 of taxable income, 15% from $49,450 to $545,500, and 20% above that. For married couples filing jointly, the 15% rate starts at $98,900 and the 20% rate at $613,700.

Those brackets look at all your taxable income, not just the sale. A seller with $90,000 in wages and $100,000 of home-sale profit after the Section 121 exclusion would see most of the gain taxed at 15% federally, which dwarfs the Arizona bill on the same money.

The 3.8% Net Investment Income Tax

Higher earners get hit with an additional 3.8% Net Investment Income Tax on capital gains when modified adjusted gross income tops $200,000 for single filers or $250,000 for joint filers.¹¹ The NIIT thresholds aren’t indexed for inflation, so more sellers cross them as home values rise. The tax applies to the lesser of net investment income or the amount by which income exceeds the threshold, so only the overage is hit.

Depreciation Recapture If You Had a Home Office

The Section 121 exclusion does not cover gain attributable to depreciation you claimed on a home office or on a rented portion of the house. Depreciation taken after May 6, 1997 must be recaptured and is taxed at up to 25% federally, even if the rest of the gain is fully excluded. If you could have claimed depreciation but didn’t, the IRS still reduces your basis by the amount you were entitled to deduct.³ This catches sellers who ran a business from home for years and never thought the eventual sale would involve a separate tax calculation.

Estimated Payments After Closing

A profitable sale can push you into Arizona’s estimated payment rules. For 2026, you generally need to make quarterly estimated payments if your Arizona gross income tops $75,000 (or $150,000 filing jointly) in both the current and prior year.¹²

To avoid an underpayment penalty, your estimated payments plus any Arizona withholding must come to at least 90% of your 2026 tax or 100% of your 2025 tax, whichever is less.¹² The IRS has a parallel rule. If you close mid-year and ordinary paycheck withholding won’t cover the added tax, sending an estimated payment soon after closing is cheaper than paying a penalty the following April.

Where the Numbers Go on Your Returns

Federally, Form 8949 lists the sale details with adjusted basis and proceeds, and the totals carry to Schedule D of your Form 1040.¹³ You must file these forms when a 1099-S was issued, even if the exclusion zeroes out the gain. No 1099-S and a fully excluded gain means no federal reporting is required.³

Full-year Arizona residents file Form 140. Nonresidents use Form 140-NR and part-year residents use Form 140-PY. Arizona has no separate capital gains schedule. You enter the net capital gain from your federal Schedule D on line 20, split it into short-term and long-term on lines 21 and 22, put any qualifying long-term gain on line 23, and calculate the 25% subtraction on line 24.¹⁴ The return starts from your federal adjusted gross income, so gain already excluded under Section 121 is simply absent from the Arizona math.²

1
Office of the Law Revision Counsel. 26 USC 121 – Exclusion of Gain From Sale of Principal Residence
2
Arizona Department of Revenue. Individual Income Tax Information
3
Internal Revenue Service. Publication 523, Selling Your Home
4
Internal Revenue Service. Publication 523, Selling Your Home – Section: Improvements
5
Internal Revenue Service. Publication 544, Sales and Other Dispositions of Assets
6
Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired From a Decedent
7
Arizona Legislature. Arizona Revised Statutes 43-1022 – Subtractions From Arizona Gross Income
8
Arizona Legislature. Fact Sheet for SB 1331 – Income Tax Subtraction; Capital Gains
9
Arizona Legislature. Arizona State Senate Fact Sheet for SB 1828 – Omnibus; Taxation
10
Arizona Department of Revenue. Identifying Other Taxable Income
11
Office of the Law Revision Counsel. 26 USC 1411 – Imposition of Tax
12
Arizona Department of Revenue. Arizona Form 140ES Individual Estimated Income Tax Payment
13
Internal Revenue Service. About Form 8949, Sales and Other Dispositions of Capital Assets
14
Arizona Department of Revenue. Individual Income Tax Forms