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Are you looking to sell a home or real estate investment?
If so, you may be anxiously anticipating the profits that can come from it.
But there is one thing that can eat away at those profits — capital gains.
It’s important to consider how the capital gains tax on real estate might impact any sale.
In this article, we’ll help you better understand the capital gains tax on real estate, as well as explain how to reduce your capital gains tax bill.
What is Capital Gains?
Let’s begin by defining capital gains.
The capital gains tax on real estate represents the money you pay when you sell property that has increased in value since it was purchased.
A capital gains tax on real estate applies when the home is sold for a higher value than its original purchase price.
The IRS requires a capital gains tax on real estate once it is sold, although exceptions may apply.
Capital gains tax on real estate can be as high as a whopping 20%, which is why lowering your capital gains tax bill is a popular topic among real estate investors.
Capital Gains Tax Calculator
How can you calculate capital gains tax on real estate property?
First, you’ll need to determine the amount that you’ve gained by subtracting your original purchase price (called the “basis”) from the amount you’ve sold the property (called “the realized amount”).
You’ll then report this amount on IRS form D.
This figure will be used to calculate the capital gains tax on real estate property.
However, be aware that other numbers factor into the equation, including:
- the amount of the sale
- your filing status
Next, we’ll look at the type of capital gains that factor into your tax bill.
Short Term vs Long Term Capital Gains
Short-term capital gains refer to profits made from a property you’ve owned for less than one year.
They are taxed as regular income by the IRS, which means they are added to your annual work income and are subject to whatever tax bracket you fall into.
In contrast, long-term capital gains refer to profits made from a property you’ve owned for longer than one year.
Since long-term capital gains are generally taxed at a more favorable rate than short-term capital gains, you as a real estate investor can minimize your capital gains tax bill by holding the property for a year or more.
According to the IRS, to determine how long you held the asset, you can generally count from the day after the day you acquired the asset up to and including the day you disposed of the asset.
There are exceptions to a property being classified as either short or long term, including:
- property acquired as a gift
- property acquired from a descendant
In either of these cases, you can use Publication 544 as a guide.
How to Reduce Capital Gains Tax on Real Estate
This may leave you wondering how to reduce or even avoid capital gains tax on real estate.
You can actually use a few strategies to reduce the capital gains tax on real estate property that you sell.
Option #1: Exclusions
What’s known as the “Section 121 exclusion”, when you sell your home, you can exclude $250,000 — $500,000 if you file a joint return — from the sale price.
In order to qualify for this exclusion, you must have owned the home for at least five years, and during those five years prior to selling your house, it must have been your primary residence for two years minimum.
Keep in mind that exclusions don’t work for every property.
For example, if the property is not the seller’s primary residence, exclusions won’t apply. But if you have been house hacking, you can likely take advantage of this option.
Option #2: Adjust Your Basis
You can increase the basis — the amount you originally paid — by including fees associated with the sale, as well as the cost of home improvements and other upgrades.
If you add an additional bedroom and bathroom to your house that costs $30,000, your new cost basis will increase by the exact amount you spent.
Option #3: Use a 1031 Exchange
The IRS Code 1031 allows you to reinvest the profits from a sale into a similar property, which can mitigate the capital gains tax on real estate you would otherwise pay.
What's more, you can use a 1031 exchange to build your wealth tax-free.
Keep in mind that properties subject to the 1031 exchange are not for personal use; they must be for business or investment purposes.
Capital Gains FAQs
Next, we’ll look at some of the most commonly asked questions associated with capital gains in real estate.
Q. When Do You Pay Capital Gains Tax?
Capital gains tax on real estate is only paid once the property is sold.
The profits are reported to the IRS and are paid as part of your annual income taxes.
Q. Capital Gains Exemption for Seniors
Prior to 1997, there were provisions that mitigated the capital gains tax on real estate when homes were sold by people over the age of 55.
Today, those provisions have been replaced by the exemptions explained above, which allow homeowners to exclude up to $250,000 from the gain from their taxes.
Capital Gains Tax on Real Estate: The Bottom Line
Capital gains tax on real estate can be both tricky and frustrating — but by understanding how to avoid capital gains tax on real estate sales, you can maximize your investment, whether you’re a homeowner or real estate investor.