Taxes are a big part of real estate. That’s because real estate has to do with money. Hopefully you are the one making more of the money, but even if you are not, you still have to pay taxes. C'est la vie.
We (hopefully) all know that purchasing a house affects our taxes. When you purchase a house, you are able to write off the interest on your mortgage as a deduction. You are also able to write off things that go toward your house, like the interest on your homeowner's insurance. What about when you sell it, though?
How does selling your house affect your taxes?
The answer to this question is going to be different depending on the circumstances of the sale and the tax. Let’s take a look at the largest tax the sale will affect.
Long-Term Capital Gains Tax
The amount of capital gains tax you pay is determined by whether or not your home is your primary residence. A primary residence is defined by the IRS as a home that you have lived in for at least two out of the last five years. If you have lived in your home for two of the last five years and decide to sell your house, you will be exempt from capital gains tax for up to $250,000 in profit if you are single, or $500,000 if you are married, filing jointly. If you make more than that on the sale of the house, you have to pay what is called longterm capital gains tax.
We’ll look at an example. Sue buys a house with her husband, Fred, for $100,000. They live there for ten years, and make renovations as well as build several additions to the sale of the house. Finally, when they list the house, it sells for $400,000. Because they are married filing jointly, and because the profit on the house ($300,000) is less than $500,000, and because they lived in the home for two out of the last five years, there is no capital gains tax to be had on the sale of that home.
Short-Term Capital Gains Tax
If for some reason, you have not lived in a home for two out of the last five years, you must pay short-term capital gains tax. Short-term capital gains tax is taxed as income tax. An example of this would be if you and your family purchase a home in a nice area for $400,000. You are very happy living in the home, and find out that you are expecting twins! You bought the house thinking your family was done growing, and don’t have enough room for this surprise. You decide to sell your home and upgrade to a larger home. You list the home and it sells for $440,000. Because you sold it for $40,000 more than you bought it for, that money is taxed as if you made that amount from your full-time job.
What about investment properties?
Investment properties are treated differently. If you are selling an investment property you've never lived in, you will pay capital gains tax on the sale of the home. You will also pay depreciation recapture taxes based on the amount you deducted from your income during your ownership of the house.
If you lived in the investment property for two of the last five years, then you would treat it as your primary residence and receive exemptions up to $250,000 or $500,000 if you are married filing jointly. An example of this would be if you bought a house and lived in it for two years before converting it to a bed n breakfast.
Is there a way to avoid taxes when selling an investment property?
No one truly wants to pay taxes, and the government rewards those that create payable jobs for others. Because of this, there is a 1031 exchange, which is a piece of tax code that allows you to defer taxes if you decide to put all of the money you made on the home back into more investment properties. If you use a 1031 exchange, you can use the money toward any three investment property, as long as it follows a set of rules.
If you are flipping a house and plan to sell it within a year of purchasing it, you’ll want to make sure that your profit is big enough to cover the capital gains tax. This is the less-than-glamorous side to flipping a home that you don’t see on tv. As with everything, it’s always a good idea to speak with a CPA about your tax options before deciding to sell your home. There may be avenues you can pursue that will prevent you from shelling out most of your profit to taxes.
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