Naturally, you desire to earn a substantial profit when selling your house. However, be cautious of a potential deduction from your earnings – the capital gains tax. If the value of your house has significantly risen, you may be accountable for a considerable amount when settling your yearly income tax.
Lucky for us, there are strategies to evade or minimize the capital gains tax when selling a house, allowing us to retain maximum profit. You’ll find all the essential information right here.
Capital Gains Tax
The capital gains tax is the tax liability on the profit, also known as the capital gain, obtained from the sale of an investment or asset. The calculation involves deducting the initial cost or purchase price of the asset (referred to as the “tax basis”), along with any incurred expenses, from the eventual sale price.
Special rates apply for long-term capital gains, which are applicable to assets owned for more than a year. Depending on your income, the long-term capital gains tax rates vary between 15 percent, 20 percent, and 28 percent (for specific asset categories such as collectibles).
Real estate, including residential properties, is considered a taxable asset. The IRS requires you to report any profits earned from selling a home and settle the corresponding tax obligations when filing your annual tax return for the year of the property sale.
Even though the capital gains tax is often lower than regular income tax rates, it can still accumulate significantly, particularly when making profits on significant investments such as a home, which is often the largest asset individuals will possess.
If your property’s value increases significantly after its purchase and you sell it to take advantage of the appreciation, you may be subject to a considerable taxable gain that relates directly to the capital gains tax.
Capital Gains Tax in Real Estate
Determining capital gains tax in real estate can prove to be intricate, as it is influenced by various factors such as the tax rate.
- Your income tax bracket
- your marital status
- how long you’ve owned the house
- if the house was your primary residence, a secondary residence or an investment property
Please be informed that the tax is solely calculated based on the profit obtained. For example, if you bought a house five years ago for $150,000 and sold it for $225,000 today, your profit would amount to $75,000.
There may be deductions you can take, such as qualifying home improvements or sale closing costs, which could decrease your net profit. Consequently, you will still be required to report the sale of your home and potentially be liable for paying a capital gains tax on the profit of $75,000.
In the case of the 2022 tax year, if you are an individual filer and have a taxable income ranging from $41,676 to $459,750, or if you are married and filing jointly with a taxable income ranging from $83,351 to $517,200, you will owe 15 percent of the $75,000 profit, equating to $11,250.
If the property being sold is their primary residence, home sellers have multiple options provided by the IRS to avoid or decrease their capital gains taxes.
If specific conditions are met, you have the opportunity to exclude a certain portion of the profit from taxation, with the maximum amount being either $250,000 or $500,000, determined by your filing status.
When it comes to taxes, rental properties have different exclusions compared to a primary residence.
Depending on your income and filing status, you would need to pay approximately 15 to 20 percent in long-term capital gains taxes on your total profit. If you received a depreciation deduction for the property, you might be required to pay up to 25 percent in some situations.
In order to avoid being taxed as ordinary income, it is advisable to extend the ownership period of a rental property that you intend to sell for a minimum of 12 months. There is no limit set by the IRS on short-term capital gains taxes, and you could potentially face a tax rate of up to 37 percent.
Calculating Tax On Your Capital Gain
Typically, your taxable capital gain corresponds to the amount you receive from the sale or exchange of a capital asset, less the initial cost or “basis” of the asset, which is usually equivalent to what you paid for it.
Determining your basis can be more complex in certain situations, even though sometimes it is a straightforward calculation; for instance, if you purchased stock for $10 and sold it for $100, your capital gain would amount to $90.
It is important to aim for the highest basis possible when selling a capital asset as it will reduce the taxable portion of your profit and ultimately result in a lower tax liability.
In addition to your initial purchase price, your basis can encompass various expenses associated with acquiring, selling, manufacturing, or enhancing your capital asset that are not currently eligible for deduction.
Keeping receipts and other records of home improvement expenses, brokers’ fees, and commissions that are clearly connected to a specific asset can increase your basis and result in a reduction of your profit when you decide to sell.
It is important to be aware that some expenses related to investments are considered miscellaneous itemized expenses, and they are not allowed until 2025. Furthermore, these expenses do not contribute to increasing your basis.
If you obtained the capital asset being sold through means other than a regular purchase, the calculations for determining its basis become more complex. For instance, in the case of inheriting an asset, the basis is typically adjusted to match the fair market value of the asset at the time of the previous owner’s death.
If a capital asset is gifted to you by someone, the basis of the donor becomes your basis too. In the case of receiving stock from your employer as part of your compensation, your basis is typically equivalent to the amount included in your taxable pay (which is reported on your W-2) that is allocated towards the securities.
If you sell an asset that you have held for more than one year, the resulting profit will be considered long-term capital gain.
To benefit from lower tax rates, it is advisable to hold capital assets for a minimum of one year since long-term capital gains are taxed at lower rates than short-term capital gains, which are subjected to ordinary income tax rates.
The rules for calculating your holding period when selling a portion of your stock in a company will vary based on how you account for the securities, such as using methods like FIFO or LIFO, as mentioned earlier in relation to determining your basis.
If you obtained your stock through means other than purchasing or engaging in a taxable transaction (such as inheritance), you might also be able to include the holding period of the person you acquired it from.
Tax Rate Applies To My Capital Gain
Once you have acquired long-term gains, it becomes crucial to determine the specific capital gains tax bracket you belong to – either the 0%, 15%, or 20% bracket.
The taxation rate applied to long-term capital gains is determined by the thresholds of your taxable income for the year, similar to how it is for your regular income and wages.
Once your total income exceeds the relevant threshold, all your capital gains are subject to a higher tax rate, unlike the tax rate brackets for ordinary income. This implies that there might be scenarios where earning a lower total income for the year could potentially be financially beneficial.
The 0% rate for 2022 is applicable to joint filers with taxable incomes of up to $83,350, head-of-household filers with incomes of up to $55,800, and single filers and married couples filing separate returns with incomes of up to $41,675.
The 15% rate is applicable to individuals whose taxable incomes range from above these thresholds up to $517,200 for joint filers, $488,500 for head-of-household filers, $459,750 for single filers, and $258,600 for married couples filing separate returns.
If your capital gains are subject to tax, you will incur a 20% tax rate if your taxable income exceeds the 15% bracket.
These amounts for inflation have been recently updated by the IRS. In 2023, the 0% rate is applicable to taxable incomes up to $89,250 for joint filers, $59,750 for head-of-household filers, and $44,625 for single filers and married couples filing separate returns.
For joint filers, the 15% rate will be applicable in 2023 if their income falls within the range of $89,250 to $553,850. Head-of-household filers will qualify for the 15% rate if their income is between $59,750 and $523,050.
Married couples filing separate returns will be eligible for the 15% rate if their income falls within the range of $44,625 to $276,900. Single filers will qualify for the 15% rate if their income is between $44,625 and $492,300.
Anyone with income exceeding these amounts is subject to the 20% rate.
If you anticipate being taxed at 20% for 2022 but expect a tax rate of 0% or 15% in 2023 due to retirement, being in between jobs, or experiencing losses on other capital assets, you may consider delaying sales transactions until next year to capitalize on the different rates available.
Instead of selling all of your assets at once and incurring a 20% tax rate, you have the option to sell capital assets gradually over multiple years which would result in a tax rate of either 0% or 15%, depending on the timeframe.
When specific assets are sold, there are special rates for capital gains tax that apply. One instance is the sale of qualified small business stock, where any gain not excluded will be subjected to a special capital gains tax rate of 28%.
The unrecaptured Section 1250 gain, which is typically the depreciation taken on real property, is subject to a discounted rate of 25%, only up to the amount of gain from selling the property.
Furthermore, profits obtained through the transactions of collectibles are subject to a 28% tax rate. This encompasses profits derived from selling artwork, antiquities, stamps, coins, gold, or any other valuable metals, gemstones, historical artifacts, or similar articles.
Please note that these special rates represent the highest rates applicable to individuals with significant incomes.
If your regular tax rate is below the special rate (such as 10%, 12%, 22%, or 24%), you might be eligible for your regular tax rate to be used for gain on qualified small business stock, Section 1250 gain, or collectibles.
Warning: Alongside the capital gains tax, there is an extra surtax that is applicable to “net investment income.” (This NII encompasses taxable interest, dividends, gains, passive rents, annuities, and royalties, among other things.)
If your income exceeds a specified limit – $200,000 for individuals, $250,000 for married couples filing jointly, or $125,000 for married individuals filing separate returns – you are typically obligated to pay an extra 3.8% surtax on any capital gains you have earned.
If you are an active participant or real estate professional, the surtax does not affect capital gains obtained from selling business assets.
Avoiding Capital Gains Tax on a Home Sale
Your bottom line can be significantly impacted by capital gains taxes. Luckily, there are methods to decrease the tax amount or completely avoid capital gains taxes when selling a home.
The ability to avoid paying capital gains taxes when selling your house depends on the type of property and your filing status, according to the IRS guidelines.
Avoiding A Capital Gains Tax On Your Primary Residence
If you sell your primary residence and fall under the single tax-filing status, you will not have to pay capital gains taxes on the first $250,000 of your earnings, and if you are married and filing jointly, you can avoid taxes on up to $500,000.
This exemption can be utilized every two years and essentially cancels out the capital gains tax.
Suppose an individual who files taxes independently purchased a house for $250,000, resided in it, and eventually sold it for $400,000 after three years.
Their profit amounts to $150,000. However, this profit remains exempt from any capital gains tax since it falls below the permitted threshold of $250,000 for gains.
Naturally, certain conditions must be met in order to consider the property your primary residence, as per the IRS regulations. The IRS necessitates providing evidence that the property was your primary dwelling where you resided for the majority of the time. It is necessary to demonstrate that:
- You owned the home for at least two years.
- You lived in the property as the primary residence for at least two out of the five years immediately preceding the sale.
Nonetheless, there is some flexibility in the way the rules can be interpreted. It is not necessary to prove that you resided in the house continuously for the entire duration of your ownership or for two consecutive years.
One possible rephrasing of the text with the same meaning could be: For instance, you have the option to buy the house, reside in it for a year, lease it out for a couple of years, and subsequently relocate to make it your main residence for another year.
You can qualify for the capital gains tax exemption if you resided in the property as your primary residence for a collective period of 24 months within the five years leading up to the sale of the home.
Avoiding Capital Gains Tax on a Rental or Additional Property
In order to reduce your tax liability, proper planning is necessary when it comes to selling a property that you own. There are various strategies available to minimize the impact of capital gains tax.
Establishing The Rental as Primary Residence
It is possible that you discover a significant increase in the value of a rental property that you intend to sell.
To prevent capital gains, it could be beneficial to reside in the rental property for a minimum of two years and convert it into your primary residence. Nevertheless, it is important to note that you will not be able to exempt the depreciated portion during the rental period.
Losing primary residency status on your main home is temporary and can be regained later by returning after selling the rental property.
If you have no intentions of selling your main home within the next two years, it will be possible for you to regain your primary residency status and later be eligible for the capital gains exclusion.
A 1031 exchange, also referred to as a like-kind exchange, can be utilized as well. However, it is important to note that this exchange is only applicable when you sell your investment property and utilize the resulting funds to purchase another property of a similar nature.
By continuously reinvesting the sale proceeds into another investment property, you can effectively delay the payment of capital gains tax indefinitely and avoid it altogether.
Opportunity Zones were established across the country due to the enactment of the 2017 Tax Cuts and Jobs Act, targeting regions that have been acknowledged as facing economic disadvantages.
Investing in a designated low-income community will grant you a tax basis increase (equals to your original cost) after the initial five years, and any profits accumulated after a decade will be exempt from taxes.