In the US, real estate investments are subject to capital gains tax once you decide to sell your property or business and make a profit on it. This can be quite confusing, especially since there are different kinds of properties and property ownerships, which all have different kinds of capital gain tax treatments.
But don’t worry; this ultimate guide will walk you through all of the ins and outs of capital gain tax on real estate in the US, including how to determine if you even need to pay this tax and what steps you can take to keep from paying too much of it.
When do you pay capital gains tax on real estate?
In short, you’ll pay capital gains tax on real estate when you sell your property and when your profits exceed your cost basis. Since every property sale is different, there are two primary ways that capital gains tax can be calculated.
First, if you purchased a property for less than $250,000 (as of 2017), you can generally avoid paying capital gains tax as long as your profits don’t exceed $250,000.
For example, if you bought a property for $100,000 and sold it 15 years later for $450,000 after making significant improvements to it—your profit would likely be higher than that $250k threshold.
Are you subject to capital gain tax on real estate if you inherit the property?
If you inherited a property, it is not subject to capital gain tax. If you sold it, however, you would have pay capital gain taxes based off what you originally paid for it.
For example, if your father bought a $200,000 house and then passed away when its value was worth $300,000; if his estate sold that house for $400,000 (after subtracting any outstanding loans against it), no capital gains taxes would apply.
On top of that exemption from capital gains tax due to inheritance (or rather because there was no gain), there are additional exemptions.
Is there an exemption for first time home buyers?
Although capital gain taxes may not be a major concern for home buyers who are able to buy their home with cash, there are plenty of buyers who need financing or need to use other sources of cash besides their own.
As such, they’ll have less money available after buying their new home and will be subject to higher taxes. Fortunately, there is an exemption for first time home buyers that can reduce your tax burden by up to $250,000 (single) or $500,000 (married).
The downside is that you must meet certain requirements that vary depending on your individual situation.
5 Ways to Avoid Capital Gains Tax on Real Estate
Capital gains tax on real estate can be tricky, especially if you don’t understand how it works and what you can do to avoid it when possible. Here are five of the most important tips to remember when it comes to avoiding capital gains tax on real estate.
1. Traditional sale: A traditional sale is where you sell your real estate property (home or business) directly to an end user. This means that they’re not a real estate professional and instead of buying it, they intend to occupy it as their primary residence or use it for business purposes.
For example, if you owned a single-family home, you could sell it in a traditional sale and avoid capital gains tax by ensuring that your profit doesn’t exceed $250,000. This was increased from $500,000 in December 2017 due to President Trump’s new tax plan.
2. Keep the receipts for your home improvements: Don’t forget to keep your receipts if you make home improvements that can be depreciated.
Costs such as painting, replacing windows, remodeling kitchens and bathrooms, installing new floors and doors, insulation upgrades, central air conditioning, radiant floor heating systems, foundation repairs and fences are considered capital expenses for tax purposes.
Your home will not only look better but be more energy efficient too. These improvements can add up over time so it’s important to know how they will help avoid capital gains tax on real estate in order to plan accordingly.
By taking advantage of these savings methods you could save yourself thousands of dollars in capital gains tax on real estate!
3. Live in the house for at least two years: If you buy a house and move in, there’s no need to worry about capital gains tax. If you sell within two years of purchase, any profits are considered short-term capital gains and are taxed at your normal income rate (up to 35 percent).
If you live in a house for at least two years, it becomes a long-term capital gain (which can be up to 15 percent), taxed at half your marginal rate. For example, if you’re single with $80,000 in income, your taxable rate will be 28 percent—half of 35 percent.
The savings here can really add up if you make more than $200K per year and buy multiple properties over time.
4. Take advantage of a 1031 Exchange: Did you know that most capital gains taxes are avoided by taking advantage of a 1031 exchange? The IRS encourages exchanges in certain situations, including when one property is sold and another property is purchased. 1031 exchanges allow people to do just that, essentially shifting assets without taking a taxable hit.
5. Invest in Opportunity Zone Funds: Opportunity Zone Funds are one way that investors can avoid capital gains tax on real estate. The rule is a simple concept: you must hold property for five years before it’s subject to taxation.
What is an Opportunity Zone Fund? In short, they help finance affordable housing in communities with low-to-moderate incomes or located in federally designated Opportunity Zones. Holders of Opportunity Zone investments are exempt from capital gains tax if they hold their investment for at least 10 years, as long as 75% of proceeds are invested in such zones.
Keep in mind that most REITs, RREM funds and other similar real estate ETFs do not invest in properties located within Opportunity Zones. Make sure you read prospectuses carefully before investing your money!
Although avoiding capital gains tax on real estate could be challenging, the few steps above could help you alleviate some of the taxes during your real estate transactions. When selling or buying property, it’s wise to work with an accountant who can help reduce your capital gains tax liability.
If you don’t feel comfortable taking on these duties yourself, hiring an attorney who specializes in real estate will certainly be worthwhile as well.