When you acquire real estate, especially your own house, the price you will get for it when you sell it is generally not your first priority. When it comes time to sell that property, though, you don’t want to sell it for less than you paid for it. Making a profit is excellent, but keep in mind that you may be subject to capital gains tax.
What are capital gains?
The difference between the buying price of an asset and the selling price when you sell it later is known as capital gains. The amount you pay is referred to as your “basis” in the asset, and it includes any improvements made to it. For example, if you purchase a property for $200,000 and make $50,000 in upgrades, your basis in the house is $250,000. Your capital gains are $150,000 if you later sell the house for $400,000.
Stocks, bonds, artwork, automobiles, and boats are just a few of the capital items that might be subject to capital gains tax.
What is capital gains tax?
Capital gains are taxed by the Internal Revenue Service (IRS) in specific circumstances. You may have made a profit on a home sale in the past, but you don’t recall paying capital gains tax. You might not have done so. Because the federal government exempts $250,000 in real estate capital gains for an individual taxpayer and $500,000 for a married couple filing jointly, this is the case. Because the capital gains in our scenario were $150,000, you would not have paid capital gains tax.
However, there are several situations in which the capital gains tax exclusions may not apply. Let’s go through what they are and what you can do to prevent or at least reduce capital gains taxes on real estate sales.
When you are at risk of capital gains tax?
The majority of homeowners do not remain in the same house for the rest of their lives. The $250,000/$500,000 capital gains tax exemptions allow people to buy a family home, sell it when they need to, and then buy a new one without paying capital gains taxes.
However, in other cases, sellers are unable to claim those exemptions. It’s crucial to know what they are in order to figure out how to avoid paying capital gains tax on real estate.
The capital gains tax deduction does not apply to a real estate transaction if the following conditions are met:
- It was not your primary dwelling that you sold (like a vacation home or investment property). A condominium, mobile home, or even a houseboat might qualify as a “primary residence” provided it fits specific standards, according to the IRS.
- In the five years leading up to the sale, you owned the real estate you sold for less than two years;
- During the five years leading up to the sale, you did not live in the house for at least two years. Military personnel, members of the foreign service or intelligence communities, and people with impairments may, however, be exempt.
- You are subject to expatriate tax (just like a US resident who has given up their citizenship);
- Within the last five years, you purchased the property through a like-kind exchange, often known as a 1031 exchange;
- You previously claimed the exclusion on the sale of another house within the two-year period before the sale of the home.
If any of the above scenarios apply to you (or if your gain exceeds your exclusion level), you will almost certainly be required to pay capital gains tax on your real estate transaction. Then there’s the question of how much. The amount of capital gains tax due on a house sale is largely determined by whether the gain is short-term or long-term.
If you possess the real estate for less than a year, such as an investment property that you “flipped,” you will be subject to short-term capital gains tax. The rate of taxation on short-term capital gains is the same as the rate of taxation on a regular income.
If you’ve owned the property for more than a year, you’ll almost certainly qualify for the lower long-term capital gains tax rate. The maximum tax rate is 20%, however many people pay significantly less.
How to avoid capital gains tax on real estate?
There are a variety of steps you can take to reduce or eliminate your capital gains tax liability. For example, if you can, dwell in a house for at least two years out of every five before selling it. While it’s common for that time to be consecutive, it’s not required; all that matters is that it totals at least two years inside the five-year term. (To qualify for the $500,000 married couple filing jointly exclusion, both spouses must have resided in the house for two years.) Vacations and other times of departure from home may count toward the two-year minimum. If you can’t afford to live in a house for two years, try to keep it for at least one year before selling it to avoid paying the more expensive short-term capital gains tax.
To qualify for the exclusion from capital gains taxes, you must meet both the two-year ownership and residence conditions, but there are several exceptions. For example, if the house was given to you by a spouse or ex-spouse as part of a divorce or otherwise, you can use your own time to meet the ownership requirement. You must, however, satisfy the residency requirement on your own. If you are widowed and have not owned and lived in the house for a minimum of two years, any time your late spouse owned and lived in the house without you can be included in the ownership and residence criteria. You must not, however, have remarried by the time you sell the house.
Even if you made a taxable gain on the sale of your house, you may be eligible to deduct some of it if the sale was due to certain circumstances. To see if you qualify, speak with an experienced tax professional.
Finally, keep in mind that your home’s base comprises not only the purchase price but also the cost of modifications. If you’ve remodeled your kitchen or bathroom, fixed your roof, or built a deck, you may be able to increase your basis by tens of thousands of dollars, lowering your taxable gains.
Final Thoughts
Selling real estate might result in a financial benefit, but you must be cautious to avoid the IRS claiming a portion of your profit. Make an appointment with Chhota CFO‘s accounting and tax preparation experts now.
