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Capital gains tax on real estate and selling your home

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When you sell your home, you may be subject to a capital gains tax because of the increase in value while you’ve owned it. Fortunately, there are ways to avoid a capital gains tax on a home sale so you can keep as much profit in your pocket as possible.

What is capital gains tax?

You pay capital gains tax when you sell certain assets for more than what you paid for them. Homes and vehicles are included, and any gains you made from them must be reported to the IRS at tax time. However, the IRS gives qualifying homeowners an exemption that can help them get around this costly tax.

How much is capital gains tax in real estate?

Calculating capital gains tax in real estate can be complex. The tax rate depends on many factors including your tax bracket, marital status, how long you’ve owned the house and whether it was an investment property or your primary residence. If you sell a house or property in less than one year of owning it, the short-term capital gains is taxed as ordinary income, which could be as high as 37 percent. Long-term capital gains for properties you owned over one year are taxed at 15 percent or 20 percent depending on your income tax bracket.

The tax is only assessed on the profit itself. If you purchased a house five years ago for $150,000 and sold it today for $225,000, your profit would be $75,000. (This is a simplified example since there are deductions you could take such as qualifying home improvements and sale closing costs.) You would need to report the home sale and potentially pay a capital gains tax on the $75,000 profit. If your taxable income is between $80,000 and $441,450 as a single filer, and up to $496,600 for married filing jointly, you would pay 15 percent on the $75,000 profit, or $11,250.

There is one caveat: The IRS gives you a tax break if the property you’re selling is a primary residence. You won’t need to pay a capital gains tax if you meet certain conditions (which are detailed later in this article).

How much is capital gains tax on rental property?

Rental properties don’t have the same exclusions as a primary residence does when it comes to taxes. As with the sale of a property that doesn’t produce income, you would have to pay between 15 and 20 percent in long-term capital gains taxes, depending on your income and filing status.

If you plan to sell a rental property you’ve owned for less than a year, try and stretch ownership out for at least 12 months, or it will be taxed as ordinary income. The IRS doesn’t have a ceiling for short-term capital gains taxes and you may be hit with a tax of up to 37 percent.

How to avoid capital gains tax on a home sale

Capital gains taxes can greatly affect your bottom line. Fortunately, there are ways to reduce the tax bill, or avoid capital gains taxes on a home sale altogether. It depends on the property type and your filing status. The IRS offers a few scenarios to avoid capital gains taxes when selling your house:

Avoiding a capital gains tax on your primary residence

You can sell your primary residence and avoid paying capital gains taxes on the first $250,000 if your tax-filing status is single, and up to $500,000 if married filing jointly. The exemption is only available once every two years. To qualify the property as your primary residence, the IRS requires that you prove that it was your main home where you lived most of the time. You’ll need to show that:

  • You owned the home for at least two years.
  • You lived in the property as the primary residence for at least two years.

However, there is wiggle room in how the rules are interpreted. You don’t have to show you lived in the home the entire time you owned it or even consecutively for two years. You could, for example, purchase the house, live in it for 12 months, rent it out for a few years and then move in to establish primary residence for another 12 months. As long as you lived in the house or apartment for a total of two years over the period of ownership, you can qualify for the capital gains tax exemption.

Avoiding capital gains tax on a rental or additional property

If you own an additional property that you plan to sell, you will need to plan ahead to lower your tax liability. Three ways to avoid the tax liability include:

Establishing the rental as primary residence

You might find that an investment property you rent and plan to sell has spiked in value. It may be a good idea to move into the rental for at least two years to convert it into a primary residence to avoid capital gains. However, you won’t be able to exclude the portion you depreciated while renting the property.

You’ll lose primary residency status on your main home, but it can always be gained later by moving back in after the sale of the rental property. As long as you don’t plan to sell the main home for at least two years, you can re-establish primary residency and qualify for the capital gains exclusion later.

1031 exchange

You can also take advantage of a 1031 exchange. Known as a like-kind exchange, it only works if you sell the investment property and use the proceeds to buy another, similar property. You’re basically putting off capital gains tax indefinitely; as long as you keep putting the sale of the proceeds into another investment property, you can avoid capital gains taxes.

Opportunity zones

The 2017 Tax Cuts and Jobs Act added Opportunity Zones —  areas around the country that have been identified as economically disadvantaged. If you choose to invest in a designated low-income community, you’ll get a step up in tax basis after the first five years. And any gains after 10 years will be tax-free.

Deduct expenses

If you still have capital gains after taking advantage of exemptions and exclusions, focus on lowering the amount of the taxable profit or gains. Some qualifying deductions 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 investment property income due to tenants unable to pay rent.
  • Cost of legal, professional and advertising fees to evict a tenant or find a new one.
  • Closing costs from the property sale.

Remember to keep organized records and documents including receipts, bills, invoices and credit card statements to support your expense claims in case you’re audited.

Written by
Cynthia Paez Bowman
Personal Finance Contributor
Cynthia Paez Bowman is a finance and business journalist who has been featured in Bankrate, Business Jet Traveler, MSN, CheatSheet.com, Freshome.com and TheSimpleDollar.com. She regularly travels to Africa and the Middle East to consult with women’s NGOs about small business development and works with select startups and women-owned businesses to provide growth and visibility.
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