If you’re selling your house or an investment property and are excited to make a good profit on it, then you’re not the only one! The IRS is also looking forward to the deal closing. That’s because the Capital Gains on real estate can be taxable. As always, these types of unique taxes are sometimes challenging to understand.
No worries; we’re here to help you understand a little more about capital gains taxes, when they can apply, and how much you can expect to pay. We also share some pointers to help you reduce capital gains taxes or possibly even avoid them.
What is Capital Gains Tax?
Capital Gains Tax is a tax applied on the difference between what you pay for an asset and how much you sell it for. For example, if you buy a home for $300,000 and sell it for $500,000, you are making $200,000. That $200,000 is considered capital gains and can be taxable.
With that in mind, the IRS approaches capital gains tax in one of two ways. If you own a property for less than a year before selling it, they will tax it as part of your regular income; this is short-term capital gains tax. However, if you own it for longer than a year, it is filed as a long-term capital gains tax, and you will pay 0%, 15%, or 20% based on your current tax bracket.
The primary concern for many is that capital gains can influence their total income and bump them into a higher tax bracket. Long Term capital gains take this into account and are therefore taxed separately. Short-Term Capital Gains are considered part of your income and taxed as such; they can bump you into a higher bracket.
If you’ve never heard of Capital Gains taxes, that may because you live in a state that doesn’t have or enforce them.
States that do not or may not enforce capital gains taxes may include:
- New Hampshire
- New Mexico
- South Dakota
Principle Residence vs. Investment Property
Real estate and capital gains can get tricky to follow because the taxes are treated differently based on who sells the property. Homeowners who sell a home have a portion of their capital gains excluded from their income; for an individual, it’s $250,000 and $500,000 for married couples that file jointly.
If a single person sells their home for $350,000, only $100,000 is considered capital gains. However, any significant repairs or improvements can reduce the taxable amount.
For a property to be considered a home or principal residence, the seller must live in for at least two of the five years before selling.
If you are selling a property that you have not lived in for two years, it lists as an investment property, and different rules will apply. For example, there is no threshold so that all capital gains will be taxable.
How do I calculate capital gains on the sale of a property?
As you know, the difference between the buying and selling price isn’t exactly an accurate number of what you stand to make. Let’s say you buy a home for $300,000, and you sell it for $500,000, but you sunk another $100,000 into it to make updates and renovations. In this case, you’ve only made a profit of $100,000.
The good news is that the IRS recognizes this, and any significant improvements to a home can be calculated into its tax basis to ensure your actual profit is taxable. But home improvements aren’t the only thing to take into consideration. You can include the following fees and costs to determine how much you make in profit and reduce it from the taxable amount:
- Closing Fees
- Document Preparation Fees
- Recording Fees
- Real Estate Broker’s Commission
- Mortgage Satisfaction Fees
- Escrow Fees
- Title Search Fees
- Attorney Fees
- Notary Fees
- Appraisal Fees
Do you have to pay taxes on capital gains if you reinvest?
Nobody likes to pay taxes, but they are a necessary evil. However, you may be able to reduce or avoid Capital Gains Tax on your investment property if you reinvest in another similar asset.
There are a few factors to consider, but essentially you will have a 45- or 180-day timeframe to reinvest in another property to reduce or avoid taxation.
How it works is based on your strategy. Let’s say you sell a home for $120,000, and $20,000 of that is considered capital gains. If you invest $110,000 into another property, only $10,000 is taxable. But if you invest the full $120,000, you will delay the capital gains tax entirely into the future. For more details, we recommend you review our comprehensive overview of how the 1031 Exchange works.