One typical way to accumulate wealth is through real estate investments. However, you must consider capital gain tax at the time of sale. Understanding the capital gains tax that applies to real estate or property might help you prepare for the future. It will help you avoid unpleasant tax surprises. Take a look at the ins and outs of capital gain tax, how it operates, and strategies to reduce your burden with the help of this comprehensive guide.
What is Capital Gain Tax?
Capital gain tax is the tax you pay on the extra money you make when you sell a significant asset like a house. Your “capital gain” is the difference between how much you paid for a property and how much it appraised for. There will be taxes on this amount. However, not all gains are the same. The amount of CGT you must pay on real estate depends on your tax rate, how long you’ve owned the property, and whether it was your main home or an investment.
Short-Term vs. Long-Term Capital Gains
A critical difference in CGT is between long-term and short-term capital gains:
- Short-Term Capital Gains: These gains apply when you sell a home you’ve owned for less than a year. You pay your standard income tax rate on short-term capital gains, which can be much higher.
- Long-Term Capital Gains: These gains apply when you sell a house you’ve owned for over a year. Most of the time, the tax rate on long-term income is smaller. Whichever number you choose, it’s between 0% and 20% of your taxed income.
This difference rewards people who keep their homes for at least a year before selling them, encouraging long-term investments.
How is Capital Gain on Real Estate Calculated?
To figure out your capital gain, you start with the property’s sale price and take away its cost base. It includes the price you paid for the house and any changes you made to it. Here’s how the formula goes:
Capital Gain = Sale Price – (Purchase Price + Improvement Costs + Selling Expenses)
Example:
Say you bought a house for $300,000, fixed it for $50,000, and sold it for $400,000. Your costs to sell, like agent fees, were $10,000.
This is how much you would gain in capital:
= $400,000 – ($300,000 + $50,000 + $10,000)
= $40,000
Your tax bill will be for this $40,000 amount.
Exemptions and Exclusions on Capital Gain Tax
Luckily, there are some things you can do to lower or even get rid of your CGT obligations. One of the best things is the Primary Residence Exemption.
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Primary Residence Exemption:
Should the home you’re selling be your primary residence, you might be able to get a big tax break. People who file as individuals can leave out up to $250,000 in capital gains, and married couples who file equally can leave out up to $500,000. In the five years before the sale, you must have lived in the home for at least two of those years.
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Investment Properties and 1031 Exchange:
You won’t be able to get the principal home exemption if the house you’re selling is an investment property. You might be able to put off paying CGT, though, if you use a 1031 swap. It lets you buy a similar property with the money from the sale without paying taxes on it immediately. This is an excellent way for real estate owners to build their businesses without paying taxes immediately.
Factors Affecting Capital Gains on Property
How much CGT you pay on the sale of your home can depend on several things, such as:
- Holding Period: As we already said, whether you have short-term or long-term capital gains depends on how long you’ve owned the land.
- Improvements Made: If you make big changes to a home, like repairs, the cost base can increase, lowering your taxable gain.
- Deductions: You can take some sale costs from your capital gain, such as agent charges, title insurance, and advertising fees.
- Depreciation: When you sell a leased property, you must “recapture” any loss you claim while renting out. The tax rate on this loss is higher than the normal capital gains rate, up to 25%.
- State Taxes: Some states have their own capital gains taxes on top of the federal CGT. It could increase your total tax bill.
How to Reduce Capital Gains Tax on Real Estate
There are several things you can do to lower your capital gains tax, for example:
- Hold the Property for More Than a Year: We already discussed how long-term capital gains are charged less than short-term gains. Keep your home for at least a year before selling it.
- Use the Primary Residence Exclusion: Use the $250,000 (or $500,000 for married couples) limit to its fullest if the property is your main home.
- Offset Gains with Losses: It may be possible to lower your capital gains if you sell businesses that aren’t doing well at the same time you sell your home. This method, called “tax-loss harvesting,” can lower the amount of capital gains that must be taxed.
- Leverage a 1031 Exchange: By reinvesting in similar properties, owners who use a 1031 exchange can put off paying capital gains tax for a long time.
- Gift the Property: You may be able to lower or get rid of your capital gains tax if you give property to family members. It is a great way to give property to heirs because it gives them a “stepped-up base” for tax reasons. For some, this could mean less or no CGT when they sell.
When Do You Have to Pay Capital Gains Tax?
When you file your tax return for the year the property was sold, you must pay capital gains taxes. Setting aside money for taxes is essential when you sell a business property or a second home. This is because the IRS wants you to pay any CGT debt along with your yearly tax return.
If you had a lot of sales, you might also need to pay your taxes over the year instead of all at once during tax season.
Conclusion
It can be hard to understand capital gains tax on real estate. But if you know what you’re doing and plan ahead, you can pay less in taxes and keep more of your profit. Talk to a tax expert at all times to make sure you’re using all the tax-saving options.
Also, Read – Understanding Rental Property Tax: Things To Know For Landlords
FAQs
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What happens if I sell a house that I inherited?
You can get a “stepped-up basis” when you receive a home. Put another way, the property’s value increases to its actual market value at the time of transfer. It might help you pay less capital gains tax when you sell it.
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Can I write off losses when I sell a house?
You can’t take losses from the sale of your own home off your taxes. You can deduct that loss if you sell a business or rent a property and lose money.
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If I refinance my home, does that change my capital gains tax?
Since refinancing isn’t the same as selling or exchanging a home, it doesn’t cause capital gains tax. However, refinancing can change your base if you use the money to make changes to your house.
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What effects do cash gains have on owning a home together?
When two or more people own a business together, they are responsible for their share of the cash gain. Each owner gets a share of the gain based on their amount of control.
