Capital Gains Tax: What It Is And How To Avoid It
There’s no better feeling than when you make money selling your home. However, if you’ve earned a large profit on the sale of your home, you might need to pay capital gains tax. Capital gains taxes are levied by the IRS when you make a profit on an asset. Understanding the capital gains tax and when it applies can help you get the most money possible from your home sale.
We’ll take a closer look at the capital gains tax and how it applies to home sales. We’ll go over what you might need to pay, the current capital gains tax rates and how you can minimize what you owe.
What Is Capital Gains Tax?
A capital asset is any type of property you own that has value. A capital asset can be tangible (like a car or a designer purse) or it can be intangible (like a trademark or patent). Your home is also a capital asset. This means that when you sell your home, you might see a capital gain. Depending on your circumstances, you might need to pay the capital gains tax if you sell your home for more than what you bought it for.
Short-term capital gains tax applies to the sale of assets held for less than a year, while long-term capital gains tax applies to those held for more than a year. The rates for short-term capital gains tax are appreciably higher than for long-term.
When you’re subject to the capital gains tax, you pay tax on a percentage of the profit you earned selling your asset. The percentage you pay depends on the type of asset you sold, your income, how long you owned the asset and how much money you made. We’ll go over how you can calculate your potential capital gains tax liability in later sections.
Keep in mind that you only need to pay capital gains taxes on excess income that you earned on the sale. You don’t need to pay the assigned tax rate on the entirety of your sale.
Let’s take a look at an example. Imagine that a decade ago, you bought a home for $250,000. You now want to sell your home because property values in your area are now higher than when you bought the house. You put your home on the market and accept an offer for $350,000. In this example, you see a capital gain of $100,000 on your home sale. If your income and asset class put you in the 20% capital gains tax bracket, you pay 20% of your profit. That’s 20% of $100,000, or $20,000. You don’t need to pay 20% of the entire $350,000 sale because you had to spend $250,000 to buy the asset.
The opposite of a capital gain is a capital loss. A capital loss occurs when you sell a capital asset for less money than you bought it for. For example, if you sell the home you bought for $250,000 for $200,000, you saw a capital loss of $50,000.
It’s logical to assume that if you must pay capital gains taxes on the sale of your home, you can also deduct losses from your taxes. Unfortunately, capital losses from the sale of a personal property that you live in aren’t deductible. You can only deduct losses associated with properties that you bought as an investment or rental property.
Capital gains taxes have special laws that dictate how much you pay. One important thing to note about capital gains taxes is that you don’t owe them until you actually sell your investment. If your home steadily rises in value over the years, you don’t need to include this as appreciation on your income. The tax is only levied when you decide to sell. This can allow you to offset your capital gains with capital losses by selling your investments at strategic times.
One of the most important factors that influence how much you’ll pay in capital gains tax on real estate is the amount of time you own the property. There are two types of capital gains taxes: short-term and long-term. Let’s look at how these different taxes apply.
Long-Term Capital Gains Tax
If you own an asset for more than a year, you’re subject to the long-term capital gains tax when you decide to sell. The specific percentage you’ll pay in long-term capital gains tax depends on your regular income. The more money you earn, the higher the percentage you’ll pay.
Long-term capital gains taxes are usually much more favorable than short-term tax rates. If you have a lower income, you might even qualify for a 0% long-term capital tax rate. Long-term capital gains tax rates range from 0% – 20%.
Short-Term Capital Gains Tax
If you own an asset for a year or less before you sell it, you’re subject to short-term capital gains taxes. The IRS considers short-term capital gains regular income. This means that any profit from the sale of your asset will contribute to your taxable income for the year. This can push you into a new tax bracket and cause you to pay a higher percentage in taxes for the year.
Let’s look at an example. Imagine that you earn a $40,000 salary and you decide to sell an asset that you’ve owned for less than a year. You sell the asset and see a capital gain of $50,000. When it comes time to do your taxes, the IRS considers your both your salary and the money you profited from the sale as regular income. You’ll need to pay taxes on a total of $90,000 for the year.
Short-term capital gains tax rates are much higher than long-term rates. Most investors try to avoid them if they can. Tax rates on short-term gains are the same as federal tax brackets and range from 10% – 37% for 2019, depending on your income.
2019 Capital Gains Tax Rates
You’re subject to the short-term capital gains tax if you sell your home less than a year after you buy it. The IRS taxes short-term capital gains using the same system of brackets as regular income. Here are the tax brackets for 2019.
|Rate||Unmarried Individuals/Single Filers||Married Individuals Filing Jointly|
If your home sale subjects you to the short-term capital gains tax, any profit you earn gets added onto your standard household income. This can push you into a new tax bracket and increase what you need to pay for the year.
Long-term capital gains taxes work a little differently. If your home sale subjects you to long-term capital gains taxes, you’ll pay a specific percentage of your profit on the sale. The percentage you pay depends on your income and tax filing status. Here are the long-term capital gains tax rates for 2019.
|Filing Status||Income Boundaries For 0% Tax Rate||Income Boundaries For 15% Tax Rate||Income Boundaries For 20% Tax Rate|
|Single||$0 to $39,375||$39,376 to $434,550||Over $434,550|
|Head Of Household||$0 to $52,750||$52,751 to $461,700||Over $461,700|
|Married Filing Jointly||$0 to $78,750||$78,751 to $488,850||Over $488,850|
|Married Filing Separately||$0 to $39,375||$39,376 to $244,425||Over $244,425|
The percentage capital gains tax you’ll pay on the sale of a long-term asset depends on your income. Many people pay 0% in capital gains taxes, but most incomes fall in the 15% range. Let’s look at an example.
Imagine that you’re single and you earn $50,000 a year. You sell a property and are subject to the long-term capital gains tax. You see a $40,000 capital gain when you close on your sale. In this example, you’d fall into the 15% tax category because your income is less than $434,550 but more than $39,375. Your capital gains tax due is 15% of the $40,000 you made on the sale. You owe the IRS $6,000.
Capital Gains Tax Exemptions
The capital gains tax code classifies assets by type. The type of asset you sell heavily influences how much you’ll pay in taxes. Retirement accounts, real estate and even collectibles all have their own tax code and set of exemptions.
Capital Gains Tax On Real Estate
If you’re feeling overwhelmed by the capital gains tax, know that there are a number of exemptions that reduce what you owe. The type of property you’re selling also influences what you’ll pay in taxes on the sale. You probably won’t owe anything at all if you’re selling your personal home. Let’s take a look at how your property type can influence what you’ll owe the IRS.
Capital Gains Tax On A Principal Residence
Your principal residence is the home that you live in for the majority of the year. Principal residence sales see the biggest capital gains tax exemptions. Some requirements you must meet to classify a property as your principal residence include:
- Long-term stays: You must live at the property for most of the year.
- Distance from work: Your principal residence must be a reasonable distance from your place of employment.
- Documented proof that you live there: This can include things like voter registration, a tax return, etc.
- Spousal agreement: If you’re married, your spouse must claim the same primary residence as you.
If you’re selling your principal residence, you’re exempt from a large amount of capital gains from your taxes, according to your filing status.
- You don’t need to pay any capital gains tax on the first $250,000 of profit on your home if you’re single.
- You pay 0% capital gains tax on the first $500,000 of profit on your home if you’re married filing jointly.
Capital gain doesn’t include any money that you spent to buy your home. Most homeowners don’t pay any capital gains taxes when they sell their primary residence. Let’s look at a few examples to illustrate why.
First, imagine that you’re single and you bought a home for $150,000 a few years ago. You sell your home for $250,000. In this example, you earned $100,000. However, the primary residence exemption allows you to exclude up to $250,000 of profit on your sale. This means that you owe nothing in capital gains taxes because you earned less than $250,000 of capital gain.
Now, imagine that you sell the same property for $450,000. You earned $300,000 worth of capital gain on your sale so you’re subject to the capital gains tax. However, you only need to pay taxes on the gain from your sale that exceeds $250,000 or $50,000 in this example. If your income puts you in the 15% tax bracket, you would pay 15% of $50,000 ($7,500) to the IRS.
Keep in mind that these exemptions only apply to principal residences. Different rules apply to investment properties.
Capital Gains Tax On Investment Real Estate
An investment property is one you own that isn’t your primary residence. It can be anything from a home you buy to flip to a rental property you lease to tenants.
You cannot claim the primary residence exemption on the sale of an investment property. All investment property sales are subject to the capital gains tax. However, you can take advantage of a number of deductions that will minimize your burden when tax season rolls around.
When you sell an investment property, you can consider all of the expenses you incurred buying and selling the property as the total cost of the asset. This total is your cost basis for the investment. The higher your cost basis, the lower your capital gain and the less you’ll pay in taxes.
For example, say you buy an investment property for $200,000. You paid $5,000 in closing costs and you also made $25,000 of improvements to the property. In this example, your cost basis is $230,000.
Now, say that you sell the property for $340,000. Your capital gain is $110,000. However, during closing, you spent $10,000 in commission for your listing agent and closing costs. You can deduct these expenses directly from your total capital gain. In this example, the total amount of capital gain that you need to pay taxes on is $100,000. If your income puts you in the 15% tax rate, you owe $15,000 on the sale of your investment property to the IRS.
Note that you can only deduct expenses that you incur, which adds improvements to the home that increase its value. Some examples of improvement costs you can deduct include:
- Remodeling a bathroom
- Replacing an old roof with a new, more durable model
- Constructing a new addition (like an extra bedroom or garage)
- Installing a home security system
Some examples of expenses that you cannot deduct include:
- Purely cosmetic upgrades (like painting the bedrooms)
- Regular maintenance and repair costs
Keep careful documentation of anything that you spend improving the property. This helps you deduct the correct amount at tax time and can be a crucial asset if you’re audited.
How To Avoid Capital Gains Tax: General Tips
Unless you’re selling your principal residence, you probably won’t be able to avoid the capital gains tax altogether. However, there are plenty of ways to reduce what you owe. Here are a few strategies you can use to limit your tax burden.
- Hold onto your assets. If at all possible, you should hold onto your investments for at least a year. This helps you avoid paying the expensive short-term capital gains tax. This is especially beneficial if you’re selling a personal property and want to take advantage of the principal residence exemption.
- Offset capital gains with capital losses. Investors can minimize their capital gains tax liability when they sell their assets after a period of loss. Depending on the type of capital asset you’re holding, you can often use your capital losses to “cancel out” any gain you saw earlier in the year.
- Sell your investments when your income is the lowest. As we’ve gone over, the percentage you’ll pay on your long-term investments depends on your income. It’s a good idea to sell your investments when your income is lower. If you’re self-employed or on a variable income, keep track of your revenue throughout the year and sell assets when your income is lower. You can also sell your assets after you retire.
How To Avoid Capital Gains Tax On Real Estate
If you’re selling your principal residence, you’ll want to take advantage of the massive exemption from the IRS. To qualify for up to $500,000 in exclusions on capital gains, you must meet the following criteria:
- Live in the home for at least 2 years. You must live in your home for at least 2 of the last 5 years for it to qualify as a principal residence. The years you live in your home don’t need to be consecutive.
- Own the home for at least 2 years. You must own your home for at least 2 years before you sell it to qualify for the lower long-term capital gains tax.
- You haven’t claimed a recent exemption. You cannot claim another exemption if you’ve claimed one during the last 2 years.
If you’re selling an investment property, you’ll almost always need to pay the capital gains tax. Here are a few strategies you can use to reduce what you owe.
- Make your investment property your primary residence. Savvy house flippers minimize their tax burden by making their investment property their primary residence during renovations. As long as you meet the above criteria, you can claim the principal residence deduction when you sell. Make sure to keep some kind of documentation that proves you lived there for most of the year, like updating your mailing and tax filing address.
- Track your expenses. Track all the expenses you incur selling and improving your investment property. Keep receipts, estimates and invoices from all contractors and create a running list of improvements you make to the property. This ensures you lower the amount of money you need to pay taxes on by as much as possible.
Final Thoughts On Capital Gains Tax
Understanding the capital gains tax code can be tough, especially for first-time home sellers. Different asset classes have different tax rates, and there are different tax rates for real estate properties as well. The good news is that your income influences how much you’ll pay in taxes. If you earn less money or you’re selling a principal residence, you might not pay anything in capital gains taxes. If you’re selling an investment property, you can deduct any costs you incur buying, selling and improving the property from your taxable gain.
No matter which type of investment you’re selling, you should hold onto it for at least 1 year before you sell. This will allow you to avoid the more expensive short-term capital gains tax.
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