In seller’s markets all over the U.S. investors and homeowners are making some serious cash from the sale of their house. Are you one of these lucky ducks? If so, you may be well acquainted with the other party that gets about 15% of your sales: The Capital Gains Tax.
It’s with any gain, really, not just real estate. You win the lottery, and you don’t actually get that 26 million that you were hoping for. Instead, you get to shovel over $3,900,000 of your gain to the IRS. Although you have probably not acquired 26 million from the sale of a property (and if you did, please let us in on your secret!), when we are working with larger numbers like those you’d see when you sell a property, 15% is a lot to lose.
There are many misconceptions and lots of confusion surrounding capital gains tax, so we’ll break it down for you nice and easy. In this article, we are going to discuss capital gains tax for real estate, and only on property where the owner of the property (the one whose name is on the title) is selling it. We discuss inherited property and capital gains in another great post. Also, we are NOT accountants. While we employ them and think they are really great, we do not give financial advice, and everything in this post is from our own research but should be carefully considered by you, and then discussed with your accountant.
Now that that’s out of the way, let’s start at the beginning.
What is Capital Gains Tax?
When you purchase in property, whether for investing or living in personally, it becomes your capital asset. When you sell the property, the difference between the amount you purchased the property for and the amount you sold the property for is called the capital gain. For example, if you buy a house for $300,000 and a few years later sell it for $340,000, you then have $40,000 in capital gains. The taxes come out of that $40,000 and the taxes can be as much as 20%. For those of you who don’t want to do the math, that’s $8,000 in taxes.
Is it the same tax rate for everyone?
Not all property owners and sellers are treated equally when it comes to capital gains tax. There is a common misconception that whether you own the property to live in personally or you are fixing it up to sell, that you pay the same amount in tax. This is simply (and sadly) not true. What are the facts when it comes to capital gains tax? Let’s take a look at specific cases.
Fixing and Flipping a Property
When you purchase a property to fix it up and sell it, many call it flipping. You have probably heard of someone or have seen a show somewhere where this happens. It usually goes like this: A couple scores an amazing deal on a not-so-amazing house. They fix it up and manage to sell it for quite a large sum of money. At the end of the show, they show this large amount of capital gains– but here’s the catch: it’s pre-tax. This means that the number you see isn’t the amount they get to pocket.
That’s because they have not lived in the house themselves or hung on to the property for more than two years. They simply bought the property to make an immediate profit– known as a short term capital gain. The hope is the profit far outweighs the amount in capital gains tax, making it seem small and insignificant. However, you pay taxes on the short-term capital gain as income tax. This means you will pay taxes on this amount the same way you would on your salary job. Remember, the amount of taxes you pay is dependent on the bracket you are in, so the more you show that you make on your tax return, the more significant percentage of tax you pay.
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Selling Your Primary Residence
If you’re selling your primary residence, a few factors determine the amount of capital gains tax you pay. Keep in mind that there are exceptions to every rule, though. It’s always a good idea to check out the IRS’ website to make sure you fall into these categories.
The first factor is the length of time you have spent in the house. If you have lived there for less than a year before you sell it, the law classifies it as a short-term capital gain. If you remember, the IRS taxes short-term capital gains as income– whether or not you live in it during that year.
The second factor is whether you have excluded a house from capital gains tax in the past five years. You are allowed to write off up to $250,000 (if filing singly), or $500,000 (if married filing jointly) of capital gains on your house. This pertains as long as you have lived in the house for two out of the five years you have owned the property, and only if you haven’t written off another property during that time. So, if you are married and file jointly, and sell your house for less than half of one million dollars, you may not have to pay any capital gains tax.
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Selling An Investment Property
This is where selling your house and taxes get a bit sticky (as if they weren’t before). If the home you are selling is an investment property, and you have lived in it for two of the last five years and didn’t exclude another one from capital gains in that time, you may not have to pay any capital gains tax on it. If you purchased the property to make money on it and you have either been renting it out or holding onto it for more than two years, you will be subject to long-term capital gains tax. This tax is the 15% we were discussing earlier, but it can be as much as 20% in some cases.
Avoiding Capital Gains Tax
Most people don’t like paying tax and would prefer to save that money instead. You should note that the only way to honestly avoid the capital gains tax is to live in the house for at least a couple of years and use your exemption. You can also write off many things on your taxes when you invest in real estate, so make sure you speak to your accountant about that.
Although there isn’t a way to avoid capital gains tax on your investment property entirely, there is a way to defer them. It’s a piece of code in the tax law known as a 1031 exchange. We won’t dive too deep into that today, but understand that it is essentially a way of taking the gains from one property and sticking it right into more investment properties. You won’t have to pay taxes on it right away, but as you go to sell your properties, you might. For more information on that, check out our complete 1031 exchange guide.
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