What Homeowners Need to Know about Capital Gains Taxes

First, what is a capital gain? It’s the profit (if any) that you make on property, such as a personal residence, that you sell after owning it for a year or more.

Capital Gains Tax is the tax on that profit.

The new Tax Cuts and Jobs Act made changes to the Capital Gains Tax, so even if you understood it in the past, it’s a good idea to brush up on your knowledge.

The $250,000 exclusion didn’t go away.

The IRS still gives each person a tax-free exemption for up to $250,000 of the profit on a personal residence. Thus, a couple with joint ownership could exclude up to $500,000 in gains, as long as they meet the residency requirements.

• They must have owned the home for at least two years.
• They must have occupied the home as their primary residence for at least two of the past 5 years.
• You must not have used the exclusion within the past two years.

Other partial exclusions do exist, so if you don’t meet these requirements, consult your tax advisor and/or review IRS Publication 523.

If your capital gain exceeds the exclusion…

Let’s assume that you and your spouse have owned a home for a number of years and your gain after paying all the costs of selling will come to $600,000. You qualify for the exclusion, so you now owe Capital Gains Tax on $100,000.

How much tax you will pay will depend upon your income. (In the past, it was dictated by your tax bracket.)

If you and your spouse earn less than $78,750 (or you as a single filer earn less than $39,375) you owe nothing.

A 15% tax will apply if you’re a single filer earning up to $434,550, joint filers earning up to $488,850, or the head of a household earning up to $461,700.

If your earnings exceed these numbers, your capital gains will be taxed at 20%.

Do keep in mind that some states also impose a capital gains tax, and very high earners could owe a 3.8% net investment income tax.

What if you inherited the home you’re selling?

If you inherited recently, you should owe little or no capital gains tax, because the tax basis of a home “steps up” upon the death of the owner.

Even if your parents paid $50,000 thirty years ago for a house that is now worth $1,000,000, you won’t owe capital gains unless it appreciates in value between the date of their death and the date of the sale. As far as the IRS is concerned, the tax basis of that home is now $1,000,000.

This “step-up” in tax basis is the reason why probate specialists advise heirs to cancel any sale that was pending prior to the owner’s death.

Careful bookkeeping can help you avoid capital gains

Since the real estate market can be volatile, you never know how much your home might appreciate over a few years. That’s especially true if you make major improvements.

Just to be on the safe side, do document those improvements and keep all the receipts with your other documents related to the home.

You can’t count repairs to the AC or replacing a torn window screen, but things like adding a deck, finishing the basement, remodeling the kitchen, replacing the flooring, installing new roofing, or trading out to energy-efficient windows and doors do count.

Those improvements do increase the value of your house and their cost will become part of your base for taxation – as long as you have the documentation to prove it.

Can real estate investors avoid capital gains tax?

Yes, but it is more complicated, and it only works if you intend to stay in the real estate investment business.

By using an IRS approved 1031 Exchange, you can sell one property and buy another without recognizing the gain – and thus not having taxable gain.

The process is complicated and is subject to strict rules and timelines, so consult with a tax advisor and/or real estate attorney well in advance of making such a move.