There is a lot of pride involved in owning a property, whether it is a primary home or a holiday bungalow. It is especially rewarding when real estate is properly compensated. But while a high sale price may be exciting in the moment, it usually comes with a potential downside. As a capital asset, any gains you make on the sale of your property are taxable. It is important to understand how capital gains apply to the home and how you can reduce their sting. A financial adviser may be able to help you if you are selling a property, so consider using one SmartAsset’s Free Advisor Matching Tool today.
What are capital gains taxes?
From personal belongings to investment products, almost all of your possessions are capital assets. This includes property such as cars or real estate and investments such as stocks or bonds. Let’s say you decide to sell one of these assets, such as your home. The profit you make on the sale could potentially result in a tax called capital gains tax.
Long-term capital gains occur when you sell an asset that you have held for more than one calendar year. Short-term capital gains occur when an asset is sold that has been held for less than a year. While tax rates vary, long-term capital gains are generally taxed less than short-term capital gains.
When do you have to pay capital gains taxes?
It is important to note that capital gains taxes only apply to realized profits. This means it applies after you sell the asset for more than its basis. If the gain is unrealized, meaning you still own the item, then this specific tax does not come into play.
The long-term capital gains tax rate varies between 0%, 15% and 20%. There are a few higher rates for certain items, but they do not apply to home sales. In contrast, short term capital gains are taxed as ordinary income, which can be at a much higher rate. Income tax rates vary between 12% and 37%.
Do you have to pay capital gains tax on real estate?
Taxes come into play almost every time you make money. So if you make a profit the sale of your property, you will likely incur capital gains tax. For example, if you bought a property six years ago for $200,000 and sold it today for $300,000, your gain would be $100,000. You would have to report that sale and possibly pay capital gains tax on the resulting gain. Then the exact tax amount will depend on your adjusted gross income (AGI), filing status, and length of ownership.
But before you can even calculate the taxes you owe, you need to determine your tax base. The basis is the amount of money you put into the property, also known as your capital investment. When selling a home, the tax basis depends on the circumstances in which you acquired your home. There are three scenarios:
If you bought your home: Cost basis starts with the purchase price and includes specific closing costs. Remodeling and construction costs that add to the property’s value or longevity also contribute to the cost basis. Finally, if you paid taxes meant for the seller, those are also added.
If you inherit your home: The cost basis begins with the value of the home at the time of the previous owner’s death. This is known as step up at the base. This is because you do not have to account for taxes on gains dating back to the purchase of the property.
If your home was a gift: The cost base for a gifted home remains consistent. So the cost basis for the previous owner remains the basis for the new owner. However, there may be some exceptions. There are also potential gift tax implications, as you must report all gifts over $16,000 (as of 2022) to the IRS. This is the annual gift tax exemption amount that goes toward the lifetime gift and estate tax exemption limit. As of 2022, it’s $12.06 million for individuals and $24.12 million for couples.
One caveat, however, is that the IRS offers a tax exemption if the property is your primary residence. However, you must prove that you own and have lived in the house for at least two years. The latter need not be consecutive.
How to avoid capital gains taxes when selling a house
If you want to make a profit on the sale of your house, you will owe capital gains taxes. However, there are some legal methods for doing so minimize these taxesas:
The 2 out of 5 year rule: You don’t have to live in the house for years consecutively, but cumulatively. This helps you meet the usage and ownership tests. As a result, you may qualify for an exclusion of up to $250,000 as an individual or $500,000 as a joint filer.
Eligible for partial exclusion: According to IRS Publication 523, certain situations may make you eligible for the gain exclusion. As long as you sold the home because of work, your health, or an “unforeseen event,” you can exclude some of your taxable gains.
Keep your home improvement receipts: The cost basis of your property includes more than its purchase price. It also includes any improvements you’ve made. The higher your cost basis, the lower your potential capital gains tax exposure.
Everyone wants to make a profit when selling their home. However, there are reporting costs, including capital gains tax. However, the tax on short-term gains is likely to result in a higher tax rate. So it may be worth holding onto a property long enough to qualify for tax on long-term profits. But note that the rules are different. Different property types can also result in changes to your potential taxes, so make sure you do your research before making a decision.
Navigating the intricacies of capital gains taxes can be challenging. If you want to understand your tax liability as you sell your home, seek professional guidance. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three financial advisors who serve your area, and you can interview your advisor matches for free to decide who is the best fit for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.
At one point or another, you will face capital gains taxes. But that doesn’t mean you can’t find other areas in your life to cut costs. If you’re an investor looking to minimize costs, consider checking out online brokerage firms. They often offer low investment fees, which helps you maximize your profit.
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