I'll admit, when you sell your home at a price higher than what you initially paid for it, it feel amazing! However, there might be a catch. The Internal Revenue Service (IRS) may want a share of that profit. This is because the profit you make from selling real estate can be subject to capital gains tax. But don't worry, there are ways to minimize or even completely avoid this tax (legally of course). Let's look into the details.
What is Capital Gains Tax on Real Estate?
When you sell a house for a price higher than what you purchased it for, the profit you make is termed as 'capital gain'. This gain can be subject to a tax known as the capital gains tax. The silver lining here is that many homeowners can avoid paying this tax on the sale of their primary residence, thanks to a specific IRS rule. This rule allows homeowners to exclude a certain amount of the gain from their taxable income.
For those who qualify for this home sale capital gain exclusion:
- Single filers can exclude up to $250,000 of capital gains.
- Married couples filing jointly can exclude up to $500,000 of capital gains.
This exemption is known as the Section 121 exclusion. However, to benefit from this exclusion, one must be aware of the rules and ensure they meet the criteria.
When is Capital Gains Tax Applicable?
You might be liable to pay capital gains tax on the entire profit from the sale of your house if:
-
The Home Wasn’t Your Principal Residence: The IRS has a broad definition of a "home", which can range from a condo, a co-op, to even a houseboat. The essential criterion is that the property should be your primary residence, i.e., where you spend most of your time. If you own multiple homes, ensure that the one you're selling is recognized by the IRS as your principal residence.
-
Short Ownership Duration: If you've owned the property for less than two years within the five-year period before selling it, you might be liable for the tax.
-
Insufficient Residence Duration: Merely owning the property isn't enough. The IRS mandates that you should have lived in the house for at least two of the five years before selling it. The good news is that these 24 months don't have to be consecutive.
-
Previous Claims: If you've already claimed the home sale capital gains exclusion for another property within two years before selling the current one, you can't claim the exclusion again.
-
Like-kind Exchange: If you acquired the house through a like-kind or 1031 exchange within the past five years, you're not eligible for the exclusion.
-
Expatriate Tax: If you're subject to the expatriate tax, which is levied on certain individuals who renounce their citizenship or U.S. residency status, you can't avail of the exclusion.
Calculating Capital Gains Tax on Home Sales
The capital gains tax you owe depends on the profit from your home sale. For simplicity, the profit is the difference between the purchase price and the selling price. For instance, if you bought a house for $200,000 a decade ago and sold it for $800,000 today, your profit would be $600,000. If you're married and filing jointly, you might exclude $500,000 from this gain, leaving $100,000 potentially subject to capital gains tax.
The rate at which this gain is taxed depends on how long you owned the property:
- Short-term Capital Gains Tax: If you owned the property for a year or less, the tax rate is equivalent to your ordinary income tax rate.
- Long-term Capital Gains Tax: If you owned the property for more than a year, the tax rates are more favorable, with many qualifying for a 0% rate. Others might pay 15% or 20%, depending on their income and filing status.
How to Avoid Capital Gains Tax on Real Estate
-
Reside in the House: Ensure you live in the house for at least two years. These two years don't have to be consecutive.
-
Check for Exceptions: Even if you have a taxable gain, you might still exclude some of it if you sold the house due to work, health, or unforeseen circumstances.
-
Maintain Receipts for Home Improvements: The cost basis of your home includes its purchase price and the cost of improvements. A higher cost basis can reduce your capital gains tax liability.
Lastly, it's worth noting that the once-available over-55 home sale exemption, which allowed homeowners aged 55 and above to exclude up to $125,000 of capital gains tax, expired in 1997. It was replaced by the current $500,000 exclusion cap, benefiting a broader taxpayer base.
The Impact on Today's Real Estate Market
Capital gains tax plays a significant role in today's real estate market. Homeowners are more cautious about selling their properties, especially if they anticipate a substantial profit that might be taxable. This can lead to reduced housing supply in the market, driving up prices and making affordability a challenge for many potential buyers.
Furthermore, the real estate market is influenced by various factors, including interest rates, economic conditions, and government policies, including tax implications. The capital gains tax, in particular, can influence homeowners' decisions on whether to sell or hold onto their properties, especially in booming markets where property values are rapidly increasing.
While the prospect of paying a capital gains tax might seem daunting, understanding the rules and exceptions can help homeowners make informed decisions. Proper planning and consultation with tax professionals can also provide strategies to minimize or even avoid the tax altogether.
Content in this article sourced from here.
