Capital Gains Tax on Real Estate
What is the Capital Gains Tax on Real Estate
Capital gains tax is the tax that is owed on the profit (the capital gain) when an investment asset (stocks, bonds, real estate, etc.) you own is sold. The capital gains tax is simply calculated by subtracting the asset’s original cost (your cost basis) and what you sell the asset for (your sale price).
Investment real estate creates two types of income. First, is the rental income that is generated from property operations, this is taxed the year it is generated. Second, are the capital gains that are taxed when the property is sold.
Profits generated from the sale of an investment asset are called a “capital gain” while assets sold for less than the investment’s basis will create a “capital loss.” The majority of the “value” created when repositioning a piece of real estate, will be captured at the time of sale.
Many people might confuse capital gains with ordinary income. Capital gains receive a more favorable tax treatment from the Internal Revenue Service (IRS). This preferential tax treatment encourages investors to buy and hold capital assets (real estate, stocks, bonds, etc.) for the long term. Ordinary income is income that is earned through a traditional job or business; including but not limited to interest income, wages, and tips. Capital gains happen when you sell a capital asset for more than it was originally purchased for. Capital gains are applied to alternative investments (boats, cars, artwork, etc.) if they were sold for more than initially purchased.
It is important to reiterate that capital gain taxes are only realized when an asset is sold for more than was purchased for. If you purchase a rental property for $1 million and 40 years later it is worth $10 million; you don’t have to pay any capital gain taxes unless you sell it.
Capital Gains Tax Selling House
If you sold a home that was your primary residence for at least two of the last five years, you don’t have to pay capital gain taxes up to a certain amount of your profits. If you’re a single filer, any profit up to $250,000 is excluded from taxes. For married couples filing jointly, the amount excluded is $500,000. To clarify, the profit is determined when you subtract the price you paid for your house from the amount you sold it for. For example; if you purchased a house for $500,000, lived in it for 2+ years, and then sold it for $750,000, you would not owe any (capital gain) taxes on the sale.
With the average home in the United States valued at $348,000, most homeowners will never have to worry about paying capital gains when they sell. If, however, you are fortunate enough to generate a profit over $250,000 or $500,000, you now have to consider the possibility of paying capital gains taxes.
For example; you paid $400,000 for your home (primary residence) and then sell it 20 years later for $1,000,000. You have now generated a profit of $600,000. You are married so the excluded amount of profit is $500,000; leaving you with a potential taxable gain of $100,000. The next step is to deduct the commission and fees from the sale, $60,000. The last step is to deduct any home improvements (capital expenditures). These home improvements are any (capital) expense that substantially adds to the value of your home and increases its useful life. You added a new roof that cost $30,000; making your taxable profit only $10,000. To recap; $1,000,000 (sale price) – $400,000 (cost of the home) – $60,000 (commission and fees) – $30,000 (capital expenses) – $500,000 (excluded profit from sale) = $10,000 (taxable profit (capital gain).
How Does Capital Gains Tax work on Real Estate
If you sell a property, that you have owned for more than one year, and earn a profit from the sale, that profit is subject to capital gains taxes. The IRS however, does provide a tax exclusion of up to $500,000 on the profit generated from the sale of your primary residence. Property sellers are also able to deduct the selling expenses they incurred during the sale process and any renovations that they completed during the time they owned the property.
Short-Term Capital Gains on Real Estate
If you are planning on selling a piece of real estate, it is important to begin thinking about what your tax exposure will be. If you sell a property that you have owned for less than one year, that is considered a short-term capital gain or loss, and it will be treated as ordinary income. Ordinary income is taxed at regular income tax rates and is subject to FICA taxes.
Long-Term Capital Gains on Real Estate
If you are selling a piece of real estate that you have owned for more than one year, that is now considered a long-term capital gain, and it will receive advantageous tax treatment. Capital gain tax rates range from; 0%, 15%, or 20%; depending on your income, in addition, high-income individuals may be subject to a 3.8% surtax. Long-term capital gains are also not subject to FICA taxes. If you are selling your primary residence that you have owned for five or more years and have lived in for two of the last five years; you may be eligible for up to a $500,000 tax exclusion (up to $500,000 of your gain will be tax-free, if you are married and filing jointly).
How Much is Capital Gains Tax on Real Estate
When selling a primary residence, vacation home, or rental property; the profits are taxed as capital gains (except for the capital gains tax exclusion on primary residences). The capital gains tax rate ranges from; 0%, 15%, or 20%, reliant on your income, plus a 3.8% surtax for high-income individuals.
What is the Capital Gains Tax Rate on Real Estate Investment Property
If you have owned an investment property for one or more years, any profit realized from the sale is considered a long-term gain. Long-term gains are taxed at one of three different rates; 0%, 15%, or 20%. If you are a high-income individual, you may be subject to a 3.8% surtax.
If you have owned your investment property for less than one year, the profit is considered a short-term gain and is treated as ordinary income, which is taxed at the normal earned income tax rates.
What Percent is Capital Gains Tax on Real Estate
When you are selling a property that you have owned for more than one year, any profits are now considered a capital gain and are taxed at a preferential tax rate. There are three capital gain tax rates; 0%, 15%, and 20%. If you are a high-income person, you might be subject to a 3.8% surtax, in addition to the 20%.
The 2023 Capital Gains Tax Rates:
– Single/married filing separately with a taxable income less than or equal to $41,675
– Married filing jointly/surviving spouse with a taxable income less than or equal to $83,350
– Head of household with a taxable income less than or equal to $55,800
– Single with a taxable income between $41,675 and $459,750
– Married filing separately with a taxable income between $41,675 and $258,600
– Married filing jointly/surviving spouse with a taxable income between $83,350 and $517,200
– Head of household with a taxable income between $55,800 and $488,500
– Anyone whose taxable income is above the 15% threshold in their category
How to Calculate Capital Gains Tax on Real Estate
The capital gains tax is only assessed on the profit from the sale of a property. If you purchased a rental property 2 years ago for $100,000 and just sold it for $200,000; the $100,000 is the profit. The next step is to calculate the selling expenses you incurred and any property renovations you might have made. If you incurred $15,000 worth of selling expenses and spent $25,000 on a renovation; you will deduct this. In this simplified example; your taxable profit would be $60,000 (taxed at the capital gains tax rate).
When do you pay the Capital Gains Tax?
Investors who have realized a capital gain from the sale of a capital asset (real estate, stocks, bonds, etc.), will owe taxes on this gain for the year that the gain was realized. For example; if you sold a stock that you have owned for one or more years during 2023 and generated a profit, this capital gain will be reported on your 2023 taxes.
If a capital asset has appreciated but, you have not sold it, the gain is considered unrealized, and there is no tax due. Unrealized gains are a tax strategy utilized by some of the wealthiest Americans.
How to Avoid the Capital Gains Tax on Real Estate
When your real estate appreciates, it is a terrific event. However, when you want to sell your property, that appreciation could cost you many thousands of dollars. Fortunately, there are several ways to avoid or defer paying the capital gains tax on the sale of your asset. Most real estate tax strategies are tax deferral strategies; not tax-free avoidance strategies. The government wants to entice investors to own property for long periods of time, while also holding a substantial amount of their wealth in real estate.
How to Avoid the Capital Gains Tax on Your House
The most popular method to avoid capital gains tax on real estate is available to homeowners who have owned and lived in their primary home for a total of two of the last five years before the sale. If this is the case, then up to $500,000 (if married and filing a joint return) or $250,000 (if single) of the profit is tax-free. This law allows you to “exclude” this profit from your taxable income and you are able to utilize this exclusion each time you sell a primary residence that you have lived in for two out of the last five years.
Since the average home value in the United States is $348,000, most homeowners will be able to completely avoid the capital gains tax on their primary residence. If, however, you are lucky enough to have exceeded the $250,000 or the $500,000 exclusion; you will need to pay taxes on the profits above these amounts. But don’t lose hope so fast. You still need to calculate all of your closing costs and fees.
Calculating your taxable profit is pretty straightforward if you have your closing documents and receipts for work previously done at your primary residence. The tax code allows you to deduct almost any type of expense you incurred when you sold your primary residence.
The first step is adding up the commission and fees paid. These fees and commissions may include appraisal fees, advertising fees, attorney fees, title fees, closing fees, document preparation fees, mortgage satisfaction fees, escrow fees, notary fees, points paid by the seller towards the buyer’s mortgage, real estate agent commissions, costs involved with clearing title clouds, settlement fees, transfer taxes and stamp taxes (usually charged by city, county and/or state governments). If you have your closing statement handy, this will break down these costs.
If you have made any substantial improvements to the property (capital expenditures), the next step is adding these up. A substantial physical improvement would include; adding a new room or garage, installing pipes, ducts, or insulation, upgrading your heating and cooling systems, upgrading a kitchen or bathroom, installing windows, doors, or a roof, and extensively upgrading your landscaping.
The last step is calculating all of the numbers. For example; let’s say you are single and you are selling a home you purchased for $200,000 and you are now selling it for $700,000. You did extensive renovations during your 10 years of ownership. First, we will deduct the original house sale price from the recent home sale price; leaving us with $500,000. Next, we will deduct the commission and fees you paid to sell your home ($35,000). Afterward, we will deduct the $150,000 you invested in capital improvements (renovations) over the years; leaving us with $315,000 of profit before taxes. Lastly, we will deduct your excluded amount as a single tax filer of $250,000. This leaves you with a taxable profit of $65,000. Not bad for selling your house for 3.5x what you originally purchased it for.
How to Avoid the Capital Gains Tax on a Vacation Property
As mentioned in the previous section above; avoiding up to $500,000 of capital gains on the sale of a primary residence is possible. For a property to be considered a primary residence, the property owner must have owned the property for at least five years, while living in the property for two of the last five years leading up to the sale.
For investors who own a rental house or vacation home and are looking to sell it in the future (and who do not mind living in the property for two years); this might be a viable option. The investor moves into the vacation property, making it their primary residence, and two years later, they are able to sell the property ad avoid up to $500,000 of capital gains (if married).
Borrowing Against Your Property’s Equity
Investors and homeowners who have built up substantial equity in their property can avoid the hassle of selling their property and merely borrow against it. When an owner chooses to refinance their property or take out a second mortgage the investor is accessing their equity totally tax-free. This is one of the best ways for property owners to capture the value that they have created. This strategy is a little riskier than other options since you are taking on more risk but, the borrower is able to adjust the second mortgage amount to fit their individual circumstances. It is also important to note that financing a property involves a number of fees that will be deducted from the loan’s proceeds.
There are two main ways for an investor to access their property’s equity via debt. First, is refinancing the property. Refinancing the property can refer to putting a first mortgage on the property that previously had no mortgage (or the previous mortgage was already paid off) or it can refer to refinancing a mortgage that is already present on the property.
When taking out a mortgage on a property that is currently free and clear of any mortgages, the process is very simple. The lender will have a loan-to-value percentage that they will lend up to (usually 70%-85% of the property’s current value) and the borrower is able to choose how much money they will like to access. If the property is worth $100k, and the lender will lend up to 80%, the borrower is able to access up to $80k of their property’s value.
The second solution is for the investor to take out a second mortgage (on primary residences this is also referred to as a home equity loan or HELOC). As mentioned above, most lenders will lend up to 85% loan-to-value on primary residences (investment properties will typically max out at 70%-75% loan-to-value). If the borrower has more than 15% or 20% equity in their property; they might be a good candidate for a second mortgage. A possible second mortgage on a primary residence might look like this; a property is worth $100k, there is a $50k first mortgage on the property and their credit union is allowing them to access up to 85% loan-to-value. This borrower is now able to access up to $35k, tax-free, from the equity on their home.
There are two main types of home equity loan products available to borrowers looking to access equity from their primary residence; home equity loans and HELOCs. Home equity loans have a fixed payment with a fixed interest rate and the borrower receives a lump sum once the process is complete. HELOCs on the other hand are a revolving line of credit with a variable interest rate. Home equity loans are great for longer-term capital requirements; such as buying a vacation home or a major renovation. HELOCs are great for emergencies, smaller home improvements, consolidating high-interest debt, etc. Any short-term capital requirements.
How to Defer Capital Gains Tax on Real Estate
Before we start digging into specific tax strategies. It is important to understand that real estate is a very tax-efficient asset class. Savvy investors are able to defer gains for many years and possibly decades into the future. With this being said, real estate is not a tax-free investment vehicle (except for the $250,000 and $500,000 primary residence profit exclusion discussed above). Real estate investors who have created large amounts of equity in their investment properties, and who are looking to sell their property, have three main options for deferring their capital gains.
The first strategy is the 1031-like-kind exchange.
The 1031 is one of the most popular capital gains tax deferral strategies and its origins date back to the Revenue Act of 1921. When you sell a property (Property A) and generate a capital gain, you are able to defer this tax by reinvesting the proceeds into a like-kind piece of real estate (Property B – the replacement property). 1031 is a tax deferral instrument because, when you sell the property, you are exchanging into (Property B); you will need to pay the deferred capital gains (for Property A and B). You are, however, able to 1031 Property B, into another property (Property C). In this scenario, you would be deferring capital gains on the exchange of properties A and B until you sell property C.
The 1031 has certain rules that must be adhered to in order to make sure that the property sale and the property purchase qualify as a 1031 exchange.
– The replacement property (Property B), must be identified within 45 days after the sale or exchange of the property that was sold (Property A).
– The replacement property (Property B) must be purchased within 180 days of the sale of the disposed property (Property A).
– In order for the 1031 exchange to be valid, any reinvestments must be made on the like-kind property (the properties must be similar in character).
– The sales proceeds from the relinquished property (Property A); must be handled by a Qualified Intermediary, a third party. The Qualified Intermediary will then wire those funds to the title company/attorney during the purchase process of the replacement property (Property B).
– The value of the replacement property (Property B), needs to be higher than the sale price of the relinquished property (Property A).
The second strategy is qualified opportunity zones (QOZs).
The qualified opportunity zone tax deferral strategy is for individuals and businesses alike. After an investor has generated a capital gain (from selling a piece of real estate, selling stocks, selling a business, etc.), they can invest this gain into 1 of the nearly 9,000 economically distressed communities that have been classified as QOZs. These investors are able to defer paying their capital gain taxes for several years. This capital gain tax deferral strategy was created through the 2017 Tax Cuts and Jobs Act to inspire economic development in certain low-income areas throughout the United States.
There are a couple of rules (nowhere near as burdensome as a 1031 exchange through) that need to be followed in order for your capital gain to be deferred through the qualified opportunity zone program.
– The capital gains must be invested within 180 days of the sale of the asset that generated the capital gain.
– The investment needs to be an equity investment, not a debt investment.
It is important to note that deferring capital gains is only the tip of the iceberg in regard to the tax advantages of a QOZ. If you hold your qualified opportunity zone investment for at least five years, the basis of the QOZ investment increases by 10%. If you hold it for at least seven years, it increases by another 5% and if you hold it for at least 10 years, the basis can be adjusted to its fair market value; in other words, if you sell it after 10 years, your gain on the QOZ investment is totally tax-free. No exchanges or deferrals are required.
The third strategy is an installment sale.
The installment sale strategy is a unique tax deferral strategy that is normally not discussed alongside 1031s or QOZs. When you sell a property, you pay capital gains on the actual funds you receive. The installment sale strategy allows a property investor who owns a rental property, with substantial equity, to offer seller financing to a buyer. The seller is able to structure an installment sale where they are delaying the receipt of capital gains over a predetermined number of years. The buyer makes regular payments to the seller (just like they would with a normal mortgage) and the seller is able to spread out their capital gains over many years. Typically, when you sell a property, the buyer gets a mortgage from a bank and the seller gets all of their funds at closing. In this strategy, the seller is also the bank.
Many small landlords that have owned rental properties for years and have decided to sell and retire are not planning on reinvesting their funds back into another property. Seller financing gives the seller a huge advantage when selling their property. They are able to command top dollar, sometimes over market price, because a potential buyer does not need to get approved for financing from a bank and make a large down payment.
For example; a seller might have a property worth $1 million. This property would normally require a buyer to put down $250,000 (25%) plus pay about $30,000 (3%) in closing costs (most to the bank). This seller could possibly sell this property for $1.1 million to an investor who only had to put down 5% or 10%, while also cutting their closing costs to just a few thousand dollars. The seller has full control over the mortgage. They could set the term of the mortgage for 25 years, at a fixed interest rate of 5%, and prohibit any pre-payment within the first 10 or 15 years (if there was a pre-payment, the seller would realize all of their outstanding capital gains).
Seller financing is a great strategy for investors with equity in their property who are not planning on reinvesting the funds into another piece of real estate.
How to Reduce Capital Gains Tax on Real Estate
Want to lower your tax bill on the sale of your property? There are several methods to reduce your capital gains on the sale of your real estate; however, not every method is applicable to each property.
The first method is to utilize your home improvements. A home improvement is a renovation or remodeling project that adds to your home’s value. This project prolongs your home’s useful life and/or adapts it to new uses. These projects would include; adding a new bathroom, remodeling a bathroom or kitchen, replacing flooring, new windows, and new doors. Make sure to keep good, detailed records that show what was done, and the total cost, and then add it to your home’s basis.
The second method is to calculate your home selling expenses and fees. Since many of these fees will not be listed on your closing statement, it is important to keep track of them and provide them to your accountant after your home sells. These selling expenses can include; real estate agent commissions, transfer taxes/recording fees, settlement or escrow fees, recording fees, advertising fees, attorney fees, mortgage points (paid towards the buyer’s loan), and appraisal fees. You most likely will not incur every fee listed above but, for the ones you do, make sure to keep detailed records.
What are Capital Losses
A capital loss occurs when a capital asset (real estate, stocks, bonds, etc.), decreases in value from the original purchase price. No capital loss has occurred until the asset is sold. At this time, the capital loss is realized. Capital losses are able to offset capital gains, which will reduce your taxable income.
For example; you purchase a property for $100,000 and sell it 3 years later for $75,000. Your capital loss is $25,000. Even if the asset fell in value during year 2, the loss is realized when it is sold (year 3).
Many investors utilize their capital losses through a strategy called “tax loss harvesting.” This strategy is to sell capital assets that have decreased in value for the exact purpose of generating capital losses. The investor is now able to offset taxable capital gains that they have realized during the same calendar year.
For many investors, it may unreasonable and odd to sell an investment that has decreased in value. However, if the investor is planning on replacing the disposed investment with a better investment or an investment that is more in line with the investor’s plan, it can make sense. Over the past few years, there is been a huge increase in exchange-traded funds (ETFs). These funds are more tax efficient than a normal mutual fund. An investor looking to transition from less tax-efficient mutual funds to ETFs might find that the best time to do so is during a bear market.
Benefits of Real Estate Tax Rates
The real estate investor who owns their property for one or more years and then sells it, their profit is taxed as a capital gain, not as earned income. This is a huge benefit to investors. Normal income tax rates are applied to earned income (income from a job). While the capital gains tax is applied to the profit generated from the sale of a capital asset (real estate, stocks, etc.).
Additionally, investors who reinvest their gains from one investment property to another investment property, are able to do this with one of the several capital gain tax deferral strategies. This includes; 1031 exchanges, qualified opportunity zones, and installment sales (seller financing deals).
In addition to the fact that capital gain tax rates are much lower than earned income, they are also unable to push investors into a new tax bracket. For example; if an investor is in the 24% income bracket and sells a property netting him a profit of $200,000, his earned income tax bracket stays at 24% and he pays only a 15% capital gains tax on the $200,000. If the profit from the sale of the property was taxed at the earned income rate, he would be pushed into the 35% tax bracket. One final tax benefit to the investor is that capital gains are not subject to FICA.
Always speak to your accountant, attorney, and financial advisor prior to making any financial decision.