Capital gains on real estate refer to the profit made when you sell a property for more than what you paid for it. This profit is subject to a capital gains tax, which is a levy imposed by the IRS.
When selling a home, here’s what you need to know about capital gains on real estate:
- Capital Gains Tax: This tax is applied only to the profit made, not the total sale price.
- Exemptions: You can exclude up to $250,000 of your gain if you’re single, or $500,000 if married and filing jointly, provided you meet certain conditions.
- Qualifying for Exclusions: The property must have been your principal residence for at least two out of the last five years.
I’m Scott Beloian, a seasoned real estate professional and the Broker/Owner of Westcoe Realtors. With experience in the Riverside real estate market, I specialize in guiding clients through the nuances of capital gains on real estate to maximize their profits while minimizing their tax liabilities.
What Are Capital Gains on Real Estate?
Capital gains on real estate refer to the profit made when you sell a property for more than what you paid for it. This profit is subject to a capital gains tax, which is a levy imposed by the IRS.
When selling a home, here’s what you need to know about capital gains on real estate:
- Capital Gains Tax: This tax is applied only to the profit made, not the total sale price.
- Exemptions: You can exclude up to $250,000 of your gain if you’re single, or $500,000 if married and filing jointly, provided you meet certain conditions.
- Qualifying for Exclusions: The property must have been your principal residence for at least two out of the last five years.
Short-Term vs. Long-Term Capital Gains
Short-term gains occur when you sell your property after holding it for one year or less. These gains are taxed at your regular income tax rate, which can be quite high depending on your tax bracket.
Long-term gains apply to properties held for more than one year. These gains benefit from lower tax rates, which are 0%, 15%, or 20% depending on your income bracket.
Holding Period: The duration for which you hold the property before selling it determines whether the gain is short-term or long-term.
Tax Rates for long-term capital gains in 2023 are as follows:
| Income Bracket (Single Filers) | Income Bracket (Married Filing Jointly) | Capital Gains Tax Rate |
|---|---|---|
| Up to $44,625 | Up to $89,250 | 0% |
| $44,625 – $492,300 | $89,250 – $553,850 | 15% |
| Over $492,300 | Over $553,850 | 20% |
How to Calculate Capital Gains
Calculating capital gains involves understanding several key terms and steps:
Purchase Price: This is the original amount you paid for the property.
Adjustments: These include costs such as legal fees, title insurance, and home improvements that add value to the property.
Cost Basis: This is the purchase price plus any adjustments. For example, if you bought your home for $300,000 and spent $50,000 on qualifying home improvements, your adjusted cost basis would be $350,000.
Selling Price: The amount you sell your property for.
Capital Gain: The profit you make from the sale, calculated as the selling price minus the adjusted cost basis.
Example Calculation:
- Purchase Price: $300,000
- Home Improvements: $50,000
- Adjusted Cost Basis: $350,000
- Selling Price: $500,000
- Selling Costs: $30,000 (including real estate agent commissions, legal fees, etc.)
- Realized Amount: $470,000 (Selling Price – Selling Costs)
- Capital Gain: $120,000 (Realized Amount – Adjusted Cost Basis)
In this example, your capital gain would be $120,000. Depending on your income bracket, you would then apply the appropriate tax rate to determine your tax liability.
Short-Term vs. Long-Term Gains: If the property was held for less than a year, the gain is taxed at your regular income tax rate. If held for more than a year, it is taxed at the long-term capital gains rate.
By understanding these elements, you can accurately calculate your capital gain and prepare for your tax obligations.
Exemptions and Exclusions
Qualifying for the Exclusion
The Taxpayer Relief Act of 1997 brought significant changes to how capital gains on real estate are taxed, providing relief to homeowners. If you sell your primary residence, you may be able to exclude up to $250,000 of the profit from your taxable income if you are a single filer, or up to $500,000 if you are married and file jointly. To qualify for this exclusion, you need to meet two key tests: the ownership test and the use test.
Ownership Test: You must have owned the home for at least two years within the five-year period before the sale.
Use Test: You must have lived in the home as your primary residence for at least two years within that same five-year period.
These two years do not need to be consecutive. For example, if you owned the home and lived in it for one year, rented it out for three years, and then moved back in for another year, you would still meet the criteria.
One important restriction is that you can only use this exclusion once every two years. So, if you sold another home and claimed the exclusion within the last two years, you won’t be eligible again until the period lapses.
Unforeseen Circumstances: If you need to sell your home due to unforeseen events like job changes, health issues, or other significant life events, you may still qualify for a partial exclusion. The IRS allows for these exceptions to ensure that life’s unexpected turns don’t penalize you unfairly.
Special Considerations for Seniors and Widowed Taxpayers
Widowed Taxpayers: If your spouse passed away and you haven’t remarried, you can still claim the $500,000 exclusion if the sale occurs within two years of your spouse’s death and you meet the other requirements. This provision helps ease the financial burden during a difficult time.
Military Personnel: If you or your spouse are on qualified official extended duty in the Uniformed Services, Foreign Service, or intelligence community, you can suspend the five-year test period for up to 10 years. This allows you to extend the period during which you meet the ownership and use tests, making it easier to qualify for the exclusion even with frequent relocations.
Divorce: If you were granted ownership of a home in a divorce settlement, you can count the time your spouse owned the home toward the ownership requirement. Both of you can also count the time the home was the primary residence of either spouse. This ensures that divorce doesn’t unfairly impact your ability to claim the exclusion.
Capital Gains Tax Over 65: There are no specific additional exemptions for taxpayers over 65 under the current tax laws. The previous one-time $125,000 exclusion for homeowners aged 55 and above has been replaced by the current $500,000 exclusion cap, which applies to all qualifying taxpayers regardless of age.
By understanding these exemptions and exclusions, you can make informed decisions and potentially save a significant amount on taxes when selling your home.
Next, we’ll cover how to report and pay capital gains tax, including the necessary forms and reporting requirements.
Reporting and Paying Capital Gains Tax
When you sell your home, it’s crucial to know how to report and pay capital gains tax correctly. Here’s a step-by-step guide to help you steer the process.
Form 1099-S
Form 1099-S is used to report the proceeds from real estate transactions. You’ll usually receive this form from the real estate agency, closing company, or mortgage lender. It includes key details like:
- Seller’s name and address
- Closing date
- Gross proceeds from the sale
- Property address or legal description
Example: If you sell your home for $400,000, the closing company will send you and the IRS a Form 1099-S with this information. You must report this on your tax return.
Schedule D
Schedule D (Form 1040) is used to report capital gains and losses from the sale of capital assets, including your home. You need to complete this form if you have a non-excludable gain.
Steps to Complete Schedule D:
- List the sale: Include the date you acquired the home, the date you sold it, and the sales price.
- Enter the cost basis: Include your original purchase price plus any improvements and selling costs.
- Calculate the gain or loss: Subtract your adjusted cost basis from the sales price.
Form 8949
Form 8949 is used to report sales and other dispositions of capital assets. Use this form along with Schedule D if you received a Form 1099-S or if you cannot exclude all of your capital gain.
How to Use Form 8949:
- Report the sale: Enter the details of your home sale, including the sales price and your cost basis.
- Adjustments: Make any necessary adjustments to the gain or loss, such as improvements or selling expenses.
Installment Sales
An installment sale allows you to defer part of the gain over time, potentially lowering your tax bracket. This method spreads the capital gains tax liability over several years, which can be beneficial.
Example: If you sell a property for $300,000 and structure it as an installment sale over 10 years, you spread the capital gains tax liability over that period. Each payment consists of principal, gain, and interest.
Form 6252: Use this form to report income from an installment sale in the year you receive the payments.
Net Investment Income Tax (NIIT)
The Net Investment Income Tax (NIIT) is an additional 3.8% tax that applies to certain net investment income, including capital gains, for individuals, estates, and trusts.
NIIT Thresholds:
- Single: $200,000
- Married filing jointly: $250,000
- Married filing separately: $125,000
- Qualifying widow(er) with dependent child: $250,000
- Head of household: $200,000
Example: If you file jointly with your spouse and have $200,000 in wages plus $75,000 in net investment income, your total income is $275,000. Since this exceeds the $250,000 threshold by $25,000, you owe NIIT on that $25,000. At a 3.8% tax rate, you’d pay $950.
By understanding these forms and reporting requirements, you can accurately report and pay your capital gains tax, avoiding any penalties and ensuring you pay the correct amount.
Strategies to Reduce or Avoid Capital Gains Tax
Tax-Loss Harvesting
Tax-loss harvesting is a strategy where you sell investments that have lost value to offset the gains from other investments, including real estate. This can help you reduce your taxable income.
Example: Imagine you have a $50,000 gain from selling a rental property, but you also have $20,000 in losses from other investments. You can use those losses to reduce your taxable gain to $30,000.
Steps:
- Identify depreciated assets: Find investments that have lost value.
- Sell depreciated assets: Sell these investments to realize the losses.
- Offset gains: Use the losses to offset your capital gains.
Repurchasing Assets: After selling the depreciated assets, you can repurchase similar assets to maintain your investment position, but be aware of the “wash sale” rule, which disallows the loss if you buy the same asset within 30 days.
1031 Exchange
A 1031 exchange allows you to defer paying capital gains tax by reinvesting the proceeds from the sale of an investment property into a similar “like-kind” property.
Key Points:
- Like-Kind Property: The new property must be similar in nature or use to the one sold.
- Deferral: Taxes on the gain are deferred, not eliminated.
- Qualified Intermediary: Use a qualified intermediary to handle the transaction.
- Timelines: Identify the replacement property within 45 days and complete the purchase within 180 days.
Example: If you sell a rental property for $500,000 and purchase a new rental property for $600,000, you defer paying taxes on the capital gains.
Converting a Second Home into a Primary Residence
Converting your second home or rental property into your primary residence can help you take advantage of the Section 121 exclusion.
Residency Requirement: You must live in the property as your main home for at least two of the five years before the sale.
Example: If you convert a rental property into your primary residence and live there for two years before selling, you can exclude up to $250,000 ($500,000 if married) of capital gains. However, any depreciation claimed during the rental period must be recaptured and taxed at a maximum rate of 25%.
Increasing Cost Basis
Increasing your cost basis can reduce the amount of capital gains tax you owe. The cost basis is essentially what you paid for the property, plus any improvements and certain other expenses.
Ways to Increase Cost Basis:
- Purchase Costs: Include fees and expenses associated with the purchase of the home.
- Improvements: Add the cost of home improvements and additions.
- Sales Expenses: Include expenses such as legal fees, advertising costs, and realtor commissions.
Example: If you bought a home for $250,000 and spent $50,000 on improvements, your new cost basis would be $300,000. If you sell the home for $400,000, your capital gain would be $100,000 instead of $150,000.
By using these strategies—tax-loss harvesting, 1031 exchanges, converting a second home into a primary residence, and increasing your cost basis—you can effectively manage and potentially reduce your capital gains tax liability.
Next, we’ll answer some frequently asked questions about capital gains on real estate, including how to avoid capital gains tax and when you need to pay it.
Frequently Asked Questions about Capital Gains on Real Estate
How to Avoid Capital Gains Tax on Real Estate?
Avoiding capital gains tax on real estate can be tricky, but there are several strategies you can use:
1. Use the *$250,000/$500,000 Exclusion:*
If you meet the ownership and use tests, you can exclude up to $250,000 of profit from the sale of your home if you’re single, or up to $500,000 if you’re married and filing jointly. You must have owned and lived in the home for at least two of the last five years before the sale.
2. Convert Your Rental Property into a Primary Residence:
If you move into your rental property and make it your primary residence for at least two years, you may qualify for the exclusion. You can’t exclude the portion of the gain attributed to depreciation.
3. Use a *1031 Exchange:*
For investment properties, a 1031 exchange allows you to defer paying capital gains tax by reinvesting the proceeds from the sale into a similar property. This can defer your tax liability indefinitely if you continue to reinvest in like-kind properties.
4. Keep Track of Home Improvements:
Increase your cost basis by including the cost of improvements. This lowers your capital gain. Save all receipts and documentation for home improvements.
5. Take Advantage of Unforeseen Circumstances:
If you sell your home due to unforeseen circumstances like job changes, health issues, or other significant life events, you might qualify for a partial exclusion. Check IRS Publication 523 for more details.
When Do You Pay Capital Gains Tax on Real Estate?
You pay capital gains tax on real estate when you sell a property for more than your adjusted cost basis and do not qualify for any exclusions or deferrals.
Key Points:
- Primary Residence: If you meet the criteria for the $250,000/$500,000 exclusion, you may not owe any capital gains tax.
- Investment Properties: If you sell an investment property, you’ll owe capital gains tax based on how long you owned it. Long-term gains (property held for more than a year) are taxed at 0%, 15%, or 20% depending on your income. Short-term gains (property held for a year or less) are taxed at your ordinary income tax rate.
- Reporting: You must report the sale on your tax return using Schedule D and Form 8949. If you received a Form 1099-S from the closing agent, it must be included in your tax filing.
What Is the One-Time Capital Gains Exemption for Seniors?
The one-time capital gains exemption for seniors no longer exists. It was replaced by the current exclusion rules under the Taxpayer Relief Act of 1997.
Current Rules:
- $250,000/$500,000 Exclusion: Seniors, like all other taxpayers, can exclude up to $250,000 of profit from the sale of their primary residence if single, or $500,000 if married and filing jointly, provided they meet the ownership and use tests.
Special Considerations for Seniors:
- Widowed Taxpayers: If your spouse passed away and you haven’t remarried, you can still claim the $500,000 exclusion if the sale occurs within two years of your spouse’s death and you meet the other requirements.
- Health-Related Moves: If you need to sell your home due to health reasons, you might qualify for a partial exclusion even if you haven’t met the two-year residency requirement.
For more detailed information, be sure to consult IRS Publication 523 or speak with a tax professional.
Conclusion
Navigating capital gains on real estate can be complex, but understanding the rules and strategies can help you save money. We hope this guide has provided you with the essential information you need.
At Westcoe Realtors, we are committed to helping you make informed decisions when selling your property. Our team provides personalized service custom to your unique situation, ensuring you maximize your profits while minimizing your tax obligations.
Riverside, California offers a dynamic real estate market with strong investment potential. Whether you’re a first-time seller or a seasoned investor, Riverside’s strategic location and vibrant community make it an attractive place to buy and sell property.
Ready to sell your home? Contact Westcoe Realtors today to get started with expert guidance and support custom to your needs.
By partnering with us, you can steer the complexities of capital gains tax and make the most of your real estate investments. We look forward to helping you achieve your financial goals.
