Capital Gains: What You Need to Know

January 17, 2018

Hey There Home Seller:

Selling your home? I bet you’re envisioning those dollar signs in your bank account right now. But what does it mean on your taxes this year? Capital Gains taxes can strip away those dollar signs in some situations, but can be avoided in others. It is necessary to know about capital gains taxes and how it can affect you, the home seller. 

Tax Payer Relief Act of 1997:

First of all, let’s all be thankful it’s 2018. If you sold a home prior to the Tax Payer Relief Act of 1997, you had to take the profits from the sale of your home and use it to buy another, more expensive house within two years or face Capital Gains taxes. The only other way out of the capital gains taxes would be if you were over 55. If you were over 55 you could take an individual tax exemption one time in your life, but only up to $125,000. 

That was 20 years ago and this is now! Thankfully the Tax Payer Relief Act of 1997 which went into effect May 7, 1997 now allows for home sellers to actually enjoy the profit from their sale. When selling your home, it’s important to know that tax deductions are available to you. Staying inside these guidelines can help keep those dollars signs in your bank account from your home sale this year.

What Exactly are Capital Gains Taxes:

Capital gains is the amount you’ve GAINED from selling your home. It is calculated by taking the net proceeds you received from selling your home minus the amount you paid for your home. Let’s say our friend John Doe purchased his home in 2002 for $250,000. It is now 2018 and his house sells for $350,000. Capital gains is $350000 (sale price)- $250000 (purchase price.) So the capital gains on John Doe’s house is $100000. 

What is the Threshold for the Tax Break?

The Tax Payer Relief Act was made to help the average person. Lucky for you, that means you won’t be paying taxes on the sale of your home unless selling your home will bring in a significant amount of money. That means from the purchase price, to now, your selling date, you would have to gain a large amount of money before being taxed.

There are two thresholds for capital gains taxes depending on if you’re single or married:

If you are single, you can make up to $250,000 in profits from selling your home before you would pay a penny in capital gains taxes.

If you are married, you can make up to $500,000 in profits from selling your home before you would pay a penny in capital gains taxes. 

Let’s go back to John Doe’s example. The $100000 in capital gains would not be taxed. It is under the threshold for both single and married couples.

Okay so what if you live in a booming area and your gains are more than the single and married threshold. You will pay a 20% tax on only the amount over that threshold. That would mean 20% on any amount over $250,000 gained if you’re single and 20% on any amount over $500,000 if you’re married. 

You’re probably reading this right now saying great! I’m under the threshold, I’m good to go. Wait! There are certain requirements you must meet before getting this tax break.

Requirements to Receive a Tax Break:

First of all, you must live in the home you’re planning to sell. Yes, the first requirement to qualify for the tax break is that this must be your primary residence! Secondly, there’s a 2-year rule. You are required to have lived in the home for a minimum of 2 years. Luckily, this rule applies over and over. You can live at a home for two years, sell it, buy a new home, then two years later sell that home and be entitled to the tax break all over again. 

Another interesting thing about the 2-year rule is that it just has to be 2 out of 5 years. It does not have to be 2 years consecutively. That means you can live in it for one, rent it out for 3 years, then live in it the fifth year and still qualify for the tax break! 

The doubled amount, $250,000 to $500,000 is very appealing for couples to get married. You can get married a short time before selling your home, and still qualify for the $500,000 threshold as long as you both have been living there for 2 years. One thing to remember is that once you get married, the two-year rule now applies to both of you! So if you’ve been living in separate houses and one of you sells your home to move-in with the other, you both now have to live together for two years before selling this home. 

Your Vacation Home:

What about your vacation home? Vacation homes are great little getaway but your family starts to complain about the drive, the extra upkeep, and well… the second mortgage. So after a while, you decide it’s time to sell your vacation home. Do I get the same tax breaks as if I sold my primary residence? The answer is no. You might as well have just sold stock shares. The Tax Payer Relief Act of 1997 was intended to help primary residence home owners but it does not cut a break to vacation home owners. 

Okay so how much am I going to pay? There’s two main factors in how much you’ll pay in capital gains taxes for the sale of your vacation home. 1- how much you paid for the house and 2- your income tax bracket. Most people will pay under 15% and those in the top tax bracket could pay up to 20%.

Your Rental Property:

You’ve been renting out a house for years now but it’s time to sell. Similar to your vacation home, this is not your primary residence. The Tax Payer Relief Act of 1997 is only intended to help with primary residences. The capital gains on the sale of your rental home will be taxed at 15% for people who fall into the 25%, 33% and 35% income tax brackets. People in the 39.6% tax bracket pay 20%.

Section 1031 of the Tax Code:

There is one saving grace for selling rental property. Okay, now I caught your attention! If you’re trying to cash out, and live your life, no this won’t help. But let’s say you found another rental property opportunity and you want to simply swap one rental property for another. In this case, there is a way to avoid paying taxes on the Capital Gains. That is with a 1031 exchange. A 1031 exchange is a swap of one business asset for another. 

There are a lot of “rules” applied to the swap such as timing, the like-asset rule, and proof of business interest. Let’s start with timing. Once you complete selling your rental property, you must identify a replacement property. You can submit up to three, as long as you close on one of them. That closing, on the new property, must be within 180 days of the sale of the old home. 

Another rule when doing a 1031 exchange is that the new property must be of “like-kind.” That phrase probably doesn’t mean what you think. You can swap an apartment building for a house or a ranch for a condo. It is a pretty liberal term! 

Finally, remember that a 1031 exchange is to swap one business asset for another. Since 1031 exchanges apply to all business transactions, not just real estate, it’s important to remember that you’re getting this break because your rental property is considered a business asset.  So you can’t opt to buy a vacation home instead of a rental home or your personal home instead of a rental home. It must be investment property.

How to Limit the Capital Gains Tax When Selling a Rental Property:

Now that you know you’re going to be taxed when selling a vacation home or rental home (unless you’re doing a 1031 exchange) it’s time to learn how to limit those taxes as much as possible. Let’s go back to the definition of capital gains. Capital gains is the amount you’ve GAINED from selling your home. It is calculated by taking the net proceeds you received from selling your home minus the amount you paid for your home. The key here is the “how much you paid for your home.” 

Deduct Home Improvements:

It’s important to keep track (and receipts) on any improvements done to your home. Let’s say you’ve added a back patio or pool. Those improvements are added to the “how much you paid for your home” end of the calculation. It increased the amount paid and therefore decreases your overall net profits. Improvements are considered anything you’ve done to improve and increase the value of your home from the condition you purchased it at. Improvements do not include maintenance and repairs. Fixing a leaking faucet, for example, is a repair and therefore cannot be deducted.

Offset Your Gain with a Loss:

We all hope the best for our stock and bond investments but if you had a bad year, you can actually use this to your advantage. Also called tax loss harvesting, offsetting your gain with a loss is a way to reduce capital gains taxes this year. If you take a hit in the stock market and have a net loss, that loss can be subtracted from your overall capital gains. Let’s say you were on the hook for $50000 in capital gains taxes, but you lost $20000 in value on either stocks and bonds, you’ll only be on the hook for $30000 in capital gains taxes. Just make sure you should sell your stocks or bonds in the same year as you sell your home.

Don’t Overdo it- Claiming Depreciation:

When you file your annual taxes, you can limit your income taxes by claiming depreciation on your rental property. Depreciation is the annual wear and tear on your property from renting it out. It can be helpful annually but it (tax wise) lowers the basis when you sell your home. This in turn increases your capital gains. This is just something to keep in mind when claiming depreciation yearly that this in turn will add to your capital gains taxes later down the road when you sell.

The Bottom Line:

Capital gains taxes have the potential to slash your bottom line, but with the right preparation and the right know-how, big losses can be avoided.  When selling your primary residence, it’s likely that you won’t pay any capital gains taxes. If selling a rental home, you have the option of a 1031. And when selling a vacation home, there are ways to reduce the amount paid. Either way, being knowledgeable about capital gains taxes can help your unique situation