There is a lot of pride associated with property ownership, whether it is a main home or a holiday bungalow. It is especially rewarding when real estate is properly compensated. But while a high sale price can 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 real estate are taxable. It’s important to understand how capital gains apply to a home and how you can lessen their sting. A financial advisor may be able to help if you’re selling real estate, so consider using SmartAsset’s free advisor matching tool today.
What are capital gains taxes?
From personal items to investment products, almost all of your possessions are capital assets. This includes assets 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 from the sale may incur a tax called capital gains tax.
Long-term capital gains occur when you sell an asset that you’ve held for more than a calendar year. Short-term capital gains arise on the sale of an asset held for less than a year. While tax rates vary, long-term capital gains are typically 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 kick in on realized gains. This means it applies once you sell the asset for more than its basis. If a gain is not realized, meaning you still own the item, then this particular tax does not apply.
The long-term capital gains tax rate ranges between 0%, 15% and 20%. There are some higher prices for certain items, but they do not apply to selling a home. Conversely, short-term capital gains are taxed as ordinary income, which can be at a much higher rate. Income tax rates range 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 on the sale of your property, you will likely face capital gains tax. For example, if you bought a property six years ago for $200,000 and sold it today for $300,000, your profit would be $100,000. You would have to report this sale and potentially pay capital gains tax on the resulting gain. The exact tax amount will depend on your adjusted gross income (AGI), filing status and length of ownership.
But before you can calculate the taxes you owe, you need to determine your tax base. Basis is the amount of money you have put into the property, otherwise known as your capital investment. For a home sale, the tax basis depends on the circumstances in which you acquired your home. There are three scenarios:
If you bought your home: The cost basis starts with the purchase price and includes certain closing costs. Remodeling and construction expenses that add to the value or longevity of the property also contribute to the cost basis. Finally, if you paid any seller taxes, those are added as well.
If you inherit your house: The cost basis starts with the value of the home at the time the previous owner left. This is known as stepping up the base. This is because you do not have to account for income taxes dating back to the purchase of the property.
If your house was a gift: The cost basis for an endowed house remains constant. Thus, 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 any gifts over $16,000 (starting in 2022) to the IRS. This is the annual gift tax exclusion amount, which goes toward the gift and estate tax exclusion limit. As of 2022, that’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 have owned and lived in the home for at least two years. The latter need not be consecutive.
How to Avoid Capital Gains Taxes When Selling a Home
If you want to make a profit on the sale of your home, you will owe capital gains taxes. However, there are some legal methods to minimize these taxes, such as:
The 2 in 5 year rule: You don’t have to live at home for years on end, but cumulatively. This helps you meet the tests of use and ownership. As a result, you may qualify for an exemption of up to $250,000 as an individual or $500,000 as a joint filer.
Qualify for partial disqualification: According to IRS Publication 523, certain situations may make you eligible for a gain exclusion. If you sold the house because of work, health or an “unforeseen event”, you can exclude some of your taxable gain.
Keep your home improvement receipts: The cost basis of your property includes more than its purchase price. It also includes any improvements you made. The higher your cost basis, the lower your potential capital gains tax exposure.
Everyone wants to make a profit when they sell their home. However, there are costs to consider, including capital gains tax. However, a short-term gains tax will likely result in a higher tax rate. So it can be worthwhile to hold onto a property long enough to qualify for long-term capital gains tax. But keep in mind that rules vary. Different property types can also lead to changes in your potential taxes, so make sure you do your research before making a decision.
Navigating the ins and outs of capital gains taxes can be tricky. If you want to understand your tax liability while selling your home, seek professional guidance. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors serving your area, and you can interview your advisors at no cost to decide who is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started 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 expenses, consider checking out online brokerages. They often offer low investment fees, helping you maximize your profit.
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