UNDERSTANDING POTENTIAL CAPITAL GAINS TAX ON REAL ESTATE

If you sold a home last year, you may be wondering how it will impact the amount of taxes you will owe this tax year. With an unpredictable real estate market, understanding the intricacies of real estate capital gains tax is more important than ever. Isabel Barrow offers valuable insights to help you be aware of potential tax implications so you can plan for what’s to come and possibly avoid unexpected tax liabilities.

Q: How does a home sale impact the amount of taxes you will owe?

A: If you were fortunate enough to make a large profit on the deal, be aware that you may have an unexpected tax bill on this capital gain. How much you may owe depends on a few key factors:

• Was it a primary residence, a secondary residence or an investment property like a rental?
• Are you single, married, divorced or widowed?
• How long did you hold the property?
• What state do you live in, and what are the relevant tax laws?

Capital Gains Exclusion for Sale of Primary Residence

If the home was a primary residence, the result is less complicated since many people may enjoy a sizable exemption on their gain – up to $250,000 for single filers and $500,000 for married couples filing jointly. This is known as the capital gains tax exclusion for primary residences. However, if you earned more than the permitted exemption, you may want to talk to your tax advisor. You can discuss with them whether you’re able to adjust your cost basis – the price you bought the home for – to account for any capital improvements made to the home, or if you qualify for the exemption at all.

Historically, the sale of a primary residence wouldn’t trigger an unexpected tax bill for most people. However, with the continued surge in real estate prices, and with more retirees downsizing out of homes that have seen steady appreciation for years, there are more situations where this real estate capital gains tax might crop up. Understanding your taxable gain is crucial to avoid surprises.

Short-Term Capital Gains Tax

If you’ve held the property for exactly one year or less, short-term capital gains tax rates would typically apply. These are generally the same as ordinary income tax rates, which are higher than long-term capital gains rates. Take note: You usually won’t qualify for the primary residence exemption if you’ve lived in the home for less than two of the previous five years, or if you’ve used this exemption for another home sale within the previous two years. This could significantly increase your tax liability.

In many states, if you’re subject to federal capital gains on the sale, there may be a chance you’ll also be subject to state capital gains tax and property tax considerations. Make sure to check what the state tax rules are where you live, as tax laws can vary significantly and impact your overall tax rate.

Q: Does the length of time you owned the home impact your tax bill for the sale?

A: Yes. Even if it’s a primary residence, if you’ve held the property for less than a year, the capital gains may be taxed at short-term capital gains rates (higher than long-term capital gains rates). And again, you generally won’t qualify for the $250,000/$500,000 exemption if you’ve lived in the home for less than two of the previous five years.

If you’ve owned the home for many years and are selling at a significant profit, you may end up owing on any gain that exceeds the primary residence exemption. With soaring property values, some sellers – especially longtime homeowners – may be over this threshold and subject to a capital gains tax.

Typically, the costs, fees and potential taxes on selling a home within the same year or two you purchased the home could negate any profit you realized in the property value. Bottom line – it’s usually not a great financial plan to flip a home unless it’s your full-time business! Real estate investors should be cautious, as frequent transactions can lead to increased taxable gains and higher tax payments. Before you make a move with one of your largest assets, it’s a good idea to get advice from your financial planner and tax professional on how this may impact your wallet and tax planning.

Q: How can you figure out at what capital gains rate you’ll be taxed for selling your home?

A: The capital gains rate that may apply when selling your home depends on a few things, such as:

• Your filing status and taxable income: Your capital gains rate is based on your income – and this includes the gains you just realized from the sale. Depending on your taxable income and filing status, long-term capital gains tax rates are either 0%, 15% or 20% for most assets held more than a year.
• Length of ownership: As mentioned, short-term capital gains (for property held one year or less) are taxed at ordinary income tax rates, which can be higher than long-term capital gains rates.

You may be able to offset some of these gains with losses—a strategy known as tax loss harvesting—regardless of the type of investment generating the loss. This means you can take stock market losses to offset your real estate gains, potentially reducing your tax liability.

Keep in mind, you may also be subject to a 3.8% net investment income tax, which means the top federal capital gains rate could come to 23.8%. Don’t forget that your state may also apply a capital gains tax (and most do), so you will have to pay that as well. Estimated tax payments may be necessary to cover these liabilities.

Adjusted Cost Basis of Home Sold

Your cost basis plays a role in capital gains exposure as well. That’s why it’s important to keep a record of all your home improvement expenses. These costs may help you increase your cost basis and, ultimately, reduce your gain. Capital improvements like a new roof or an added room can add significant value to your home. After factoring in the money spent on home improvements, this could take you back within the $250,000/$500,000 exemption and help you avoid paying more in capital gains tax.

Q: Are there any other factors that can impact your tax bill after you sell a home?

A: Other factors that might impact your tax bill are expenses related to improving the property. If a project was considered a capital improvement, it may be something you can add back to your cost basis. However, if you own the property as a rental or investment property, the taxation is very different. While you don’t benefit from the primary residence exemption, you do get a tax break during the years you owned it as a rental by depreciating the property.  

If you're a real estate investor involved in commercial real estate or other investment properties, being aware of these tax laws is crucial. Confused yet? This is exactly why it’s important to run these scenarios by your financial planner and tax professional before you make a decision that could have long-term implications. They can help guide you on tax deductions, taxable capital gains and how to manage your assets effectively.

Q: What can you do to lower your tax bill if you sold your home last year?

A: Be sure to gather all documented records of home improvement expenses. You may also be able to deduct certain fees or expenses related to the sale. These typically include expenses like advertising the property, appraisal fees, legal fees, closing costs and a few others. Talk to your tax preparer to determine what qualifies for deduction and how it affects your taxable gain. This proactive approach can help minimize your tax burden and potentially lower your overall tax rate.

Q: If you’re planning to sell your home in the future, how can you better prepare for the potential tax consequences?

A: To prepare for a home sale, no matter how far in the future it may be, it’s important to retain your records. Save everything related to capital improvements on your home. Create a file with your receipts and expenses and save them – these may be important even 20 years from now. While you can’t take a deduction for these expenses on a primary residence, when it comes time to sell, you may need them to show that your cost basis is much higher, reducing your taxable capital gain.

Also, if you get divorced or your spouse passes away, you have a limited period to sell the property and still get the larger $500,000 capital gains exemption for joint filers before the $250,000 single filer status applies. There are a few other conditions that may impact whether you qualify for the exemption. This can significantly impact your tax liability and estate planning.

Planning ahead and being aware of the potential tax implications of a home sale can go a long way toward minimizing the financial impact. Real estate investing involves more than just buying and selling; it requires careful consideration of tax laws and potential liabilities. To learn more about how to prepare for managing your taxes after the sale of a home, contact us today to connect with one of our financial planners.