What is Property Capital Gains Tax?
Capital Gains can be taxed on many things such as stocks, bonds, metals, but in this article we are going to refer to real estate capital gains.
Since capital gains tax an be as high as income tax, it's important to explore ever possible option to minimize the tax hit.
Capital Gains Tax Basics:
A capital gain is defined as "the difference between the sales price you received and your basis in the asset." Usually the basis of a asset is what was paid for it, however improvements, costs and other expenditures and can be written off to offset the tax burden. If you’ve depreciated the asset, that decreases your basis too.
Two examples of Capital Gain Tax Rates:
There are two different tax rates for capital gains used in California.
- Short-Term Capital Gains. Short-term capital gains are taxed at ordinary income tax rates. This is the same rate that you pay on work wages or interest income. The tax rate you must pay varies based on your total taxable income, but you can expect to pay somewhere between 10% and 39.6% as of 2015. Ouch!
- Long-Term Capital Gains. Long-term capital gains are taxed at more favorable rates. Current tax rates for long-term capital gains can be as low as 0% and top out at 20%, depending on income. Capital gains are considered to be long-term if the owner holds the asset for at least a year.
Are there Exclusion for Sale of Primary Residence?
The short answer is Yes! There are some special rules around capital gains and home sales. If you’re selling a property that has been your primary residence for at least two of the past five years, you can take full advantage of the IRS capital gain exclusion. The IRS offers a generous capital gain exclusion to taxpayers who sell their primary residence: A single taxpayer can exclude $250,000 worth of the gain on the sale of a home, and a couple can exclude $500,000.
What if I have owned this property for less then two years?
Regardless of what personal or investment asset you’re selling, there are some basic rules you should always follow to minimize your capital gains taxes. Here are a few examples of ways that you may reduce or possible avoid paying capital gains all together.
1. Wait at Least a Year Before You Sell
So that capital gains qualify for long-term status (and a lower tax rate), wait until you’ve held the asset for at least one calendar year before you sell it. Just 12 months would make the property be taxed as "Long Term" which can save save 10% to 20%.
2. Sell When Your Income is Low
Your income level impacts the amount of long-term capital gains tax you pay. Taxpayers in the 25%-35% tax brackets pay 15% on longer-term capital gains. Taxpayers in the 39.6% bracket pay 20%. If you are in the 10-15% bracket then you pay no long term capital gains tax at all. If your spouse or yourself has quit their job or if you are about to retire, selling your home during a low income year can help avoid paying capital gains completely.
3. How to reduce your taxable income
It's important to make every effort to maximize your deductions and credits before you file your tax return. For instance, donate goods to charity and take care of expensive medical procedures before the year’s end. Contribute to your IRA or 401K can help maximize you deductions. Consider purchasing bonds issued by states, local governments, and municipalities, rather than corporate bonds.
4. Keep Records of Home Improvements
Keep detailed records of any home improvements you’ve made to your home over the years. In addition to increasing your home’s value, any improvements that you make to your home increase your basis in the home and thereby reduce your capital gain dollar for dollar. This tax-savings strategy can be particularly valuable if you have a gain because the property doesn’t qualify for the primary residence exclusion, or you’ve exceeded your exclusion amount.
According to the IRS, an improvement is anything that betters your home, adapts it, or restores your home to a previous condition. Adding rooms, a deck, a pool, a retaining wall, or landscaping the property all count as improvements. Upgrading windows and doors, plumbing, insulation, heating, cooling, or sprinkler systems also qualify, as does restoring damaged parts of your home, remodels, new flooring, and built-in appliances. Retain copies of receipts and records and keep a log of all the purchases you’ve made.
5. Track Selling Expenses
Capital gains are reduced by any expenses that you incur to sell the home. If you have a taxable capital gain because you’ve exceeded your exclusion or the property doesn’t qualify, reporting these expenses will reduce your capital gain amount.
While you can’t deduct cleaning or maintenance expenses from your reported selling price, there are many other selling costs that qualify. Settlement fees, broker commissions, escrow and closing costs, advertising and appraisal fees, points paid by the seller, title search fees, transfer taxes, and any miscellaneous document preparation fees can all reduce your capital gain. As with home improvements, keep records and receipts in case the IRS wants to see them.
Avoiding Capital Gains on Investments
There are multiple tax avoidance strategies that work particularly well for investments such as stocks, bonds, retirement funds, and rental properties.
1. Use a Retirement Account
You can use retirement savings vehicles such as 401ks, traditional IRAs, and Roth IRAs to avoid capital gains and defer income tax. With 401ks and traditional IRAs, you can invest in the market using pre-tax dollars. You’ll never pay capital gains on the earnings, although you will pay ordinary income tax when you withdraw the income. Investing this way can save you a bundle on taxes if you’re in a low-income tax bracket when you retire.
However, you shouldn’t automatically assume that you’ll be in a lower bracket upon retirement. Although your income may decrease upon retirement, so do your potential deductions. If you won’t have deductions like student interest payments and mortgage interest payments, and you can’t claim your child as a deduction, your retirement tax bracket could potentially be the same as your pre-retirement tax bracket.
If you’re not sure whether you’ll be in a lower tax bracket at retirement, a Roth IRA is another way to avoid capital gain taxes. Like 401ks and traditional IRAs, gains aren’t taxed while in the account. Unlike 401ks and traditional IRAs, taxpayers can only contribute post-tax earnings to a Roth IRA account. However, the withdrawals are tax-free.
2. Gift Assets to a Family Member
If you don’t want to pay 15% or 20% in capital gains taxes, give the appreciated assets to someone who doesn’t have to pay as high a rate. The IRS allows taxpayers to gift up to $13,000 per person, per year without incurring any gift tax. That means that you could gift appreciated stock or other investments to a family member in a lower income tax bracket. If the family member chooses to sell the asset, it will be taxed at his or her rate, not yours. If he or she is in the 10% or 15% ordinary income tax brackets the year of the sale, capital gains tax could be avoided entirely.
This is a great way to pass on financial support or gifts to family members while minimizing capital gains tax. Note, however, that the tactic doesn’t work well for gifting to children or students under the age of 24. These dependents have to pay at their parents’ tax rates if they have unearned income from any sources – such as capital gains or interest income – that exceeds $2,000. This so-called “Kiddie Tax” means that any tax benefits are usually reversed if the asset is sold.
3. Exchange Rather Than Sell
Exchanging assets is another legitimate tax trick to defer capital gain taxes. Exchanging like-kind assets allows you to defer the gain until you finally sell the asset you exchanged for. The IRS allows like-kind exchanges – referred to as 1031 exchanges- for real estate and other investment assets.
A like-kind exchange occurs when you sell one asset and buy another asset of the same type within 180 days. You don’t necessarily have to swap assets with one person to qualify for the exchange and defer the gain. However, proceeds from the asset you sell must go through a qualified intermediary, and the proceeds must be used to purchase the new asset.
4. Donate to Charity
If you donate your appreciated asset to a charity or nonprofit that you support, you’ll get a nice tax deduction along with no capital gains taxes. For example, say that you bought stock for $1,000 and it’s currently worth $6,000. If you donate that stock to your favorite charity, you can claim a charitable contribution of $6,000 on your taxes. What’s more, you don’t have to pay capital gain taxes at all, even though the stock appreciated by $5,000. Since charitable organizations are tax-exempt, the charity doesn’t have to pay capital gains taxes either.
One last thought.
There are a few other things to consider. If you choose to rent out your old house instead of selling it, you’re in danger of losing the exclusion. To qualify for the exclusion, you must have lived in the home for two of the five years prior to the home sale. That means that the exclusion starts to phase out once you start to rent your house for three years, and you can potentially lose the exclusion completely. To avoid this situation and minimize your taxes, sell your home within three years of moving out or converting it to a rental.
Also, please consider that this was written by a Real Estate Agent. By no means should this be considered your go too tax advice. Make sure you contact your CPA or trusted adviser.