Capital gains on a home sale is a tax on the profit made on the sale of an asset. This also includes selling your house. In simple words, paying real estate taxes on any profit made from your home’s sale may be required.
In this blog post, we’ll dive into what capital gains tax is, and who is required to pay it.
What is Capital Gains Tax on Real Estate?
Capital gains tax is a tax on the profit made from the sale of a primary residence or an investment property. When you sell a property for more than what you originally paid for it, you make a capital gain. Likewise, you may owe property taxes by state on that gain.
It’s important to note that capital gains tax on real estate is separate from other taxes you may owe. These include state and local transfer taxes, recording fees, and real estate agent commissions.
How Does Capital Gains Tax Work?
Whether you pay capital gains tax depends on factors like:
- Income bracket: The tax category you fall into based on your income.
- Marital Status: Whether you are married or own the property jointly.
- Tenure of Your Ownership: The time for which you have been the owner of the property.
- Type of property: Whether the property is your primary residence or a secondary home or an investment.
For primary residences, the tax rules are more lenient. You can exclude up to $250,000 in profit if you’re single, or $500,000 if you’re married and file jointly. To qualify for the exclusion, own and live in the property for 2 of the 5 years before the sale.
For investment properties, you’ll generally owe taxes on the entire amount of your capital gain.
Types of Capital Gains Tax
Capital gains or losses on your asset depend on the time period you owned it for. There are two types of capital gains tax:
- Short-Term Capital Gains Tax: It applies to a home owned for one year or less before it is sold. The tax rate is the same as your regular income tax rate, which can range from 10% to 37% depending on your income level.
- Long-Term Capital Gains Tax: It applies to a home owned for more than one year before it is sold. For most taxpayers, the long-term capital gains tax rate is 15%, while taxpayers in the highest tax bracket may pay a rate of 20%.
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✍️ IMPORTANT
If you have occupied the place for a total of 24 months, non-consecutively, it will be considered your primary residence.
Capital Gains Exemptions
The Internal Revenue Service (IRS) provides several exemptions that can reduce or eliminate capital gains tax liability for certain taxpayers.
- Singles: Unmarried individuals can exclude the first $250,000 of their home sale profit from taxation. You can use this exemption once every 2 years.
- Married Couples: Couples filing a joint return are exempt from paying $500,000 from the earned net proceeds.
- Divorcees: Divorced people can claim a $250,000 exemption. For that, you have to own and live in your primary residence for at least 2 years.
- Widowers: A widow can claim the same capital gains exclusion as their spouse would have been entitled to. Before making any exemptions, certain conditions such as owning a primary residence and getting remarried are considered.
- Military Personnel: They are eligible for certain tax breaks, which reduce their capital gains tax liability. Likewise, disability compensation and survivor benefits are generally not taxable and therefore not subject to capital gains tax.
- Government Officials: Some officials may qualify for capital gains tax breaks if it is directly related to their work, like relocation expenses.
It’s important to note that divorce-related or inherited home sales can be complex. Likewise, they can have multiple tax implications. Homeowners should consult with a qualified tax professional to ensure they are taking advantage of all available tax breaks.
How to Avoid Capital Gains Tax on Real Estate?
If you’re looking to avoid paying capital gains tax, here are some strategies you can consider:
- Take advantage of the capital gains exclusion: This is one of the most straightforward ways to avoid paying capital gains tax. Live in your primary residence for at least 2 years before selling it. That way, you become eligible for capital gains tax exclusion of up to $250,000 individually.
- Time your sale strategically: If you’re close to the two-year ownership and residency requirement but haven’t quite met it yet, you may want to consider waiting.
- Do a 1031 exchange: A 1031 exchange allows you to defer paying capital gains tax by reinvesting the proceeds from the sale of one property into another “like-kind” property. This can be a complex process and requires following specific rules and timelines, so it’s important to work with a qualified intermediary and consult with a tax professional.
- Donate your home to charity: Donating your home to a qualified charity can be a way to avoid capital gains tax. Likewise, you can also support a cause you care about.
- Hold onto your home until death: When you pass away, your heirs will receive a step-up on a basis. In simpler terms, it means the cost basis of your home is changed to the value it would have had if it was sold on that date. This can reduce or eliminate capital gains tax liability for your heirs when they sell the property.
- Remodel, expand, or landscape your home: You can deduct costs spent on any of these renovations from the taxable amount you owe.
» Tax Deductions for Homeowners: Check out how you can maximize your savings by taking advantage of these 7 tax breaks!
Final Word
Understanding capital gains tax on real estate is crucial for anyone who is planning to sell their home. By knowing how capital gains tax works, you can make informed decisions and maximize your profits.
Likewise, it’s important to consult with a qualified tax professional. They can help you understand your tax liability and explore strategies for reducing it. Remember, each strategy has its own benefits and drawbacks, and the right approach will depend on your unique circumstances.
Overall, with the right knowledge and guidance, you can navigate the complex world of capital gains tax on real estate.
FAQs
1. What is the 2 in 5 year rule?
Homeowners with more than 1 property can consider the 2 in 5-year rule. IRS exclusions allow capital gains on only one of the properties. The property needs to be your primary residence for 2 years from the last 5 years of its ownership.
2. When do I pay capital gains tax?
You pay capital gains tax when you sell your property. Capital gains tax rates vary depending on various factors like your income bracket, tax-filing status, the tenure of the property ownership and the status of your residency at the property.
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