Do you know about capital gains taxes on real estate? Here we explain everything you need to know
September 10, 2022
When buying a second home, we almost always do it as a long-term investment, thinking that this acquisition today will have a greater value in the future and that we could have it as an asset to sell if we need money or simply to obtain a good profit from our investment. And yes, that’s great, but we must keep in mind that, with the increase in value of our home, the amount of income tax could also increase substantially.
We all want to have the maximum profit when we sell our house, that is why, in this article we show you how you can avoid or reduce the payment of capital gains tax on real estate, so that you are left with more money in your pocket and all in a legal way.
Capital gains tax is the amount of tax that is due on the gains earned on an investment or asset when it is sold. The tax is calculated by subtracting the original cost of the real estate or the original purchase price of the asset which is known as the “Taxable Value” plus all expenses incurred from the final sale price.
It is important to mention that, capital gains categorized as “Long Term” and which are on assets owned for more than one year, special tax rates apply. Currently, the capital gains tax rates for long-term assets are: 15%, 20% and 28% depending on income.
It should be noted that real estate, including commercial real estate, counts as an impossible asset. Therefore, any gain from the sale of a home must be reported to the IRS, you are required to make the calculation and pay the money due when you file your tax return for the year in which the sale of the real estate took place.
We should mention that capital gains tax can accumulate, this is especially true for gains on items of a costly nature, such as a house. Also, we must remember that the capital gains tax is directly related to the value of the property and any increase it has during its existence. For example, if your house appreciated just after you bought it, and you realized the appreciation when you made the sale, you could have a substantial impossible gain.
How much is the capital gains tax on real estate?
It is important to mention that, proceeding with the calculation of real estate capital gains taxes can be a bit complex, this is because the tax rate depends on several factors that affect the percentage that the taxpayer must pay, among the main factors are.
- The income tax bracket
- The taxpayer’s marital status
- The length of time you have owned the property
- Whether the home was a primary, secondary or investment residence.
It is important to mention that the tax to be paid is calculated on the minimum profit, that is to say; if you bought a property 5 years ago for a value of $150,000 and sold it for $2250,000 your profit would be around $75,000 (this is an approximate, there can always be other expenses) your declaration of sale of the property and basis for the payment of capital gains tax would be approximately $75,000.
Let’s look at a more detailed example. Assume for 2022 your income is between $41,676 and $459,750 as single and between $83,351 and $517,200 for married filing jointly, you would pay 15 percent on the $75,000 gain, or $11,250.
The IRS provides the ability to avoid or at least minimize the percentage payable on the total sale of your home, i.e., the capital gains tax. Mainly, if the property sold was your principal residence. The amount to be exempted ranges from $250,000 to $500,000 depending on your filing status.
How much is the capital gains tax on rental property?
It is important to note that properties used for rental purposes do not have the same exclusions as a primary residence, so the taxes to be paid may be very different.
For that reason, on the total gain from the sale, you must pay between 15 and 20 percent which is allocated to long-term capital gains tax, depending on your income and marital status. In some cases, you may pay up to 25% if you had previously claimed a deduction for the depreciation of the property.
Caution, if you plan to sell your rental property, which you have owned for less than one year, we recommend that you hold that property for at least 12 months, otherwise you will be taxed at the ordinary rate. You should know that the IRS does not have a cap on short-term capital gains taxes, so you may have to pay up to 37% tax on the sale of your property.
Avoiding the payment of capital gains tax on real estate
As we had mentioned, capital gains taxes can have a considerable impact on the final result of the sale of a property, affecting the total income of the taxpayer, since for example: In case of selling the newly acquired property in less than 12 months, the IRS will give you the category of “Ordinary Income” so you could be taxed with up to 37% of the capital gain.
There are legal ways to reduce or eliminate this tax, but you must understand what your current situation is and based on that choose which is the best way to sell your property. We will show you as “Scenarios” the different ways to reduce or eliminate the capital gains tax.
Scenario 1: Single marital status
In case your marital status is single, you can sell your property for up to $250,000 and exempt it from paying the tax. It is important to mention that the $250,000 is capital gains, i.e., purchase – sale = gain.
Scenario 2: Marital status married
- In case your marital status is married, you can exempt the tax up to $500,000 by filing a joint return.
- You owned the home for at least two years.
- You lived in the property as a principal residence for at least two of the five years immediately preceding the sale.
There are always ways to maneuver the interpretation of the tax rule, so you do not necessarily have to have lived in the property for 2 years to benefit from the capital gains tax exclusion. For example, you could buy the house, live in it for 12 months, then move to another home, rent out the one you bought, and then when you decide to sell it, you can move again and live in it for the other 12 months, as long as you have lived there for 24 months, no matter what order you did it in.
Avoiding Capital Gains Tax on Rental Properties
If you own a property which is rented, you can benefit from the exoneration of the payment of capital gains tax, to achieve this you must plan well in advance the sale of the property. We explain how you can achieve a tax reduction or even exonerate the total of the profits.
1: Establish the property as your main residence
The first option is to move into the rental property for at least 24 months, thus proving to the IRS that it is your new principal residence, thereby avoiding capital gains; however, you should keep in mind that you will not be able to exclude the portion that you depreciated while the property was rented.
You should also keep in mind that you will lose the status of principal residence in your main home, but this is not a big problem, since after selling the property you can move to your previous property and live there for another 24 months and apply for recognition of that property as your main home.
2: Using the 1031 exchange
You can take advantage of a 1031 exchange. This type of exchange is known as a “Like-Kind Exchange” and can only be used if you sell an investment property and use the proceeds to purchase another property, which must be similar to the one sold. With this strategy the seller is postponing capital gains tax indefinitely, this is a good strategy if you plan to invest using the exchange method; however, the moment you try to liquidate that asset for cash, you will have to pay capital gains tax.
3: The Opportunity Zone
This is a strategy that may not apply to many, as it involves properties in low-income communities. That is; you can invest in a “Safety Zone” which is categorized as an area of the country that has been designated as economically disadvantaged. Should you decide to invest in a designated low-income community, you can obtain an increase in the impossible basis (i.e.; the original cost) after the first five years. Any gain after the 10 years will be tax-free.
4: Expense Deduction
From capital gains, you can reduce the amount of tax by applying verifiable expenses to the property. This is done through deductions which may include.
- The cost of repairs to a home or investment property.
- Improvements and upgrades, such as adding a bedroom or renovating a kitchen.
- Losses in income from investment properties due to tenants being unable to pay rent.
- Cost of legal, professional and advertising fees to evict a tenant or find a new one.
- Closing costs for the sale of the property.
It is very important that you keep records and invoices of expenses, so that you can verify all information in case you are audited.
Article publidhed on September 10, 2022 by Josh Smith
Last Update September 10, 2022 by Josh Smith