If you’re thinking about selling real estate, one thing that you need to keep in mind is the amount of taxes you’re going to pay on that sale.
There’s a lot of money involved in selling property, and anytime money swaps hands, you can bet that Uncle Sam is coming for his piece of the pie.
Uncle Sam’s piece of the pie is called the capital gains tax. And the capital gains tax on real estate works a lot differently than other forms of taxes.
So today, we’re going to take a close look at the capital gains tax on real estate, and also give you 2 strategies to avoid this tax altogether.
In this post, we’re going to break down the capital gains tax on real estate transactions to help you understand and minimize any taxes you might owe.
Of course, this is not legal advice and we are writing this post for informational purposes only.
Alright, let’s talk about the capital gains tax.
What is a Capital Gains Tax?
The capital gains tax is a tax on capital assets, like stocks, bonds, homes, and other types of assets.
Now, you are only assessed a capital gains tax when a person “realizes” a gain.
For example, if you bought a home and that home appreciated by $100,000, you would not pay any capital gains taxes based on the fact that your home appreciated.
But the moment you sell your home, then you “realize” the gain and would then be subject to capital gains taxes.
So basically, you are only assessed a capital gains tax when you sell your assets.
And you would only pay capital gains taxes on the difference between your purchase price and your sales price.
For example, if you bought a $200,000 home and later sold it for $300,000, you would only pay capital gains taxes on the difference of $100,000.
Now, let’s discuss the two types of capital gain taxes.
In a moment, we’ll tell you how you can pay no capital gain taxes but let’s first look at the two basic types.
Types of Capital Gain Taxes
The two types of capital gains taxes are short-term and long-term capital gains taxes.
A short-term capital gains tax is assessed when you sell a piece of property that you’ve owned for less than 1 year.
A long-term capital gains tax is assessed when you sell a piece of property that you’ve owned for greater than 1 year.
With that said, you may be wondering why does this matter and which type of capital gains tax is better?
Both of these taxes are taxed differently.
At the time of this post, short-term capital gains are taxed as a part of your ordinary income.
This means you would pay ordinary income taxes on the sale of your real estate based on the tax bracket that you’re in.
For example, if your income puts you in the 30% tax bracket, your capital gains tax would be taxed at 30% as well.
Long-term capital gains are taxed differently. It is still based on your income, but the taxes are limited to up to 20%.
For example, if you’re single and earn over $40,000 per year, but less than $430,000 per year, then your capital gains tax would only be 15%.
As you can see, long-term capital gains are more favorable in terms of tax treatment.
In this example, the difference of 15% on a $100,000 capital gain would save you $15,000 if you’re in the 30% tax bracket.
But what if you did not have to pay any taxes on your capital gains?
What if you could avoid this tax altogether?
Fortunately, there are a few ways to minimize or avoid these taxes altogether. So let’s take a look at these tax strategies.
Strategies to Minimize or Avoid Capital Gain Taxes
Tax Strategy #1: Section 121 Exclusion
This tax strategy is for people who are trying to sell their primary residence.
If you’re selling investment property, hold on for a moment here because we have a strategy for you too.
Section 121 of the tax code allows homeowners to exclude a portion of their capital gains when they sell their primary residence.
If you’re single, you can exclude up to $250,000 of the capital gain. And if you’re married, you can exclude up to $500,000 of the capital gain.
Now, there are a couple of requirements that you need to be aware of.
The requirement that trips most people up is that you must have lived in the residence for a minimum of two years during the most recent 5-year period.
So if you only lived in the residence for 1 year and sold it, you would not qualify for this exclusion.
But on the other hand, if you lived in the residence for 1-year, rented it out for 2 years, and then returned to live there for another year again, then you would qualify.
The 2 years you lived in the residence do not have to be consecutive years.
Tax Strategy #2: 1031 Exchange
This tax strategy is used by real estate investors to defer capital gains and build wealth.
A 1031 exchange is a swap of one investment property for another investment property.
Basically, it allows you as the investor to sell one of your properties and subsequently acquire another investment property without realizing capital gains.
You’re essentially replacing one property with another property to eliminate your capital gains taxes.
However, you must acquire the next property within a specific amount of time in order for it to qualify as a 1031 exchange.
The first time limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties.
The second limit is that you must close on the replacement property no later than 180 days after the sale of the exchanged property.
Now there’s a lot more that goes into a 1031 exchange, like the property being “like-kind” and other stipulations.
So, be sure to check out our blog regularly to learn more about how all of that works.
Contact us today to get started.