Arizona Capital Gains Tax on Home Sale: 25% Subtraction and 2.5% Rate

Arizona’s capital gains tax on a home sale is usually small or zero. The federal exclusion under Internal Revenue Code Section 121 shelters up to $250,000 of profit for single filers and $500,000 for married couples filing jointly, and because Arizona starts its return with your federal adjusted gross income, any excluded gain never reaches the state calculation. Whatever profit remains gets another 25% cut under Arizona law before the state’s 2.5% flat income tax rate applies. Sellers with very large gains, investment properties, or a home office typically owe the most.

Why Most Sellers Owe Arizona Nothing

Section 121 lets you exclude up to $250,000 of gain from selling your primary residence, doubling to $500,000 on a joint return if at least one spouse owned the home and both lived in it as a primary residence for at least two of the five years before the sale. The ownership and use periods don’t have to overlap or run consecutively.¹

Arizona’s income tax begins with your federal adjusted gross income.² Anything you exclude federally is simply absent from the Arizona return. The state inherits the exclusion without any separate election on your part.

Investment properties, vacation homes, and rentals that were never your primary residence don’t qualify for the federal exclusion, so the full gain flows through to Arizona.

Arizona’s 25% Subtraction and 2.5% Flat Rate

Under Arizona Revised Statutes 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, the asset must have been acquired after December 31, 2011.³ Starting with the 2026 tax year, the subtraction applies to all qualifying long-term gains regardless of when the asset was acquired.⁴

Arizona replaced its graduated brackets with a flat 2.5% income tax rate beginning in the 2023 tax year, and it treats capital gains as ordinary income.⁵⁶

Here’s how the pieces fit together. A single filer sells a primary home for a $350,000 profit. The first $250,000 is excluded federally and never touches the Arizona return. Of the remaining $100,000, Arizona lets you subtract $25,000, leaving $75,000 subject to the state’s 2.5% rate. Arizona tax owed: $1,875.

If the home was received by gift or inheritance, Arizona treats the acquisition date as the date the original owner acquired it. If that date can’t be verified, the subtraction is denied.³

Calculating the Gain

Your gain isn’t simply sale price minus purchase price. The IRS uses your adjusted basis, which is typically higher than what you originally paid.

Start with the purchase price from your settlement statement. Add capital improvements: 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 count. Routine maintenance like repainting or fixing a faucet does not.⁷

Certain purchase-side closing costs also increase basis, including title insurance, survey fees, and transfer taxes. On the selling side, real estate commissions, title and escrow fees, and transfer taxes reduce the amount realized, lowering your taxable gain.⁸ Keep receipts, contractor invoices, and both closing disclosures.

Inherited Property

If you inherited the home, your basis is generally its fair market value on the date the previous owner died, not what they paid. This stepped-up basis under IRC Section 1014 can dramatically reduce or eliminate taxable gain.⁹ If the executor elected an alternate valuation date six months after death on an estate tax return, that value becomes your basis instead. A date-of-death appraisal is the strongest documentation.

A parent buys a home for $120,000; it’s worth $450,000 at their death; you sell for $475,000. Your gain is $25,000, not $355,000.

Situations That Change the Answer

Selling Before Two Years

Selling before you’ve lived in the home for two full years doesn’t automatically kill the exclusion. If the move is triggered by a work relocation (new job at least 50 miles farther from the home than the old job), a health condition requiring diagnosis or treatment, or certain unforeseen events like divorce, multiple births from the same pregnancy, involuntary conversion, or a natural disaster, you can claim a prorated exclusion.¹⁰

The math: divide the months you lived in the home by 24, then multiply by $250,000 or $500,000. Fourteen months of residency before a qualifying job transfer gives a single filer roughly $145,833 of exclusion.¹⁰

Home Office Depreciation Recapture

If you claimed depreciation for a home office or rented out part of the house, the Section 121 exclusion does not cover the portion of gain attributable to that depreciation. Any depreciation taken after May 6, 1997 must be recaptured and taxed at up to 25% federally, even when the rest of your gain qualifies for full exclusion.¹⁰ If you should have claimed depreciation but didn’t, the IRS still reduces your basis by the amount you could have deducted.

The Federal Bill Is Usually Larger

Arizona’s 2.5% is only part of what you’ll pay. The federal government taxes long-term capital gains at 0%, 15%, or 20% depending on your total taxable income. For 2026, single filers pay 0% on gains up to $49,450 of taxable income, 15% between $49,450 and $545,500, and 20% above that. Joint filers hit the 15% rate at $98,900 and the 20% rate at $613,700. These brackets apply to your total taxable income, not just the sale gain.

A seller with $90,000 in wages plus $100,000 in post-exclusion home sale profit would have most of that gain taxed at 15% federally, producing a federal bill far larger than the Arizona amount on the same profit.

Net Investment Income Tax

If your modified adjusted gross income exceeds $200,000 as a single filer or $250,000 on a joint return, an additional 3.8% Net Investment Income Tax applies to capital gains above those thresholds.¹¹ The tax hits the lesser of your net investment income or the amount your income exceeds the threshold. These thresholds are not indexed for inflation.

Estimated Payments After Closing

A profitable sale can trigger Arizona’s estimated payment requirements. For 2026, quarterly payments are generally required if your Arizona gross income exceeds $75,000 (or $150,000 for married filing jointly) in both the current and prior year.¹²

To avoid an underpayment penalty, estimated payments plus any withholding must total at least 90% of your 2026 tax liability or 100% of what you owed for 2025, whichever is less.¹² The same logic applies federally. Sending a payment shortly after closing beats paying a penalty in April.

Reporting the Sale

If the closing agent issues a Form 1099-S, you must file Form 8949 and Schedule D federally even when the gain is fully excluded.¹⁰¹³ If no 1099-S was issued and the exclusion covers the entire gain, federal reporting can be skipped.

Full-year Arizona residents file Form 140; nonresidents and part-year residents use Form 140-NR or Form 140-PY. Arizona has no separate capital gains schedule. Enter the net capital gain from federal Schedule D on line 20, split it into short-term and long-term on lines 21 and 22, put qualifying long-term gain on line 23, and calculate the 25% subtraction on line 24.¹⁴ Because the return starts from federal adjusted gross income, any Section 121 exclusion is already baked in.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
Arizona Legislature. Arizona Revised Statutes 43-1022 – Subtractions From Arizona Gross Income
4
Arizona Legislature. Fact Sheet for SB 1331 – Income Tax Subtraction; Capital Gains
5
Arizona Legislature. Arizona State Senate Fact Sheet for SB 1828 – Omnibus; Taxation
6
Arizona Department of Revenue. Identifying Other Taxable Income
7
Internal Revenue Service. Publication 523, Selling Your Home – Section: Improvements
8
Internal Revenue Service. Publication 544, Sales and Other Dispositions of Assets
9
Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired From a Decedent
10
Internal Revenue Service. Publication 523, Selling Your Home
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