It’s a good feeling when you’ve sold your house – you can relax, focus on finding a new home and hopefully walk away with extra cash in your pocket. However, some homeowners must deal with the IRS getting a cut of the sale, which makes the capital gains tax one of the biggest concerns when selling a property. Fortunately, there are a few strategies that can help you avoid paying this tax and hold on to more of your money.
What is the Capital Gains Tax?
The capital gains tax is a government fee you pay to the IRS when you make a profit from selling financial investments such as stocks, bonds or tangible assets like cars, boats and real estate you’ve owned for at least one year. Therefore, when you sell your home for more than you paid for it, you might be subject to this tax. Of course, selling your property for a profit is the goal for any seller, and one reason working with an experienced real estate agent is important.
When you make money from selling a property, you will be forced to pay either a short-term or long term capital gains tax depending on whether you resided in the house and how long you lived there. Depending on the amount of time, there are short-term and long-term capital gains.
With short-term capital gains, you pay higher taxes on properties you’ve owned for less than one year because short-term capital gains are taxed at the same rate as ordinary income, which is usually around 25%. With long-term capital gains, you get the benefit of a reduced tax rate that typically doesn’t exceed 20%.
The IRS also has exceptions for capital gains taxes on real estate. If you’re single, the IRS allows you to exclude up to $250,000 of capital gains if you meet the tax requirements. Married couples are allowed to exclude up to $500,000.
For example, imagine you’re married and you bought your house together in 2009 for $300,000. The property sold this year for $900,000, which means you made a profit of $600,000 over ten years. In this case, the IRS will exclude $500,000 of the $600,000, but they will tax you a percentage of the remaining $100,000. (Of course, selling a house in divorce will bring different considerations.)
For another example, imagine you’re single. You purchased your house five years ago for $100,000 and sold it this year for $250,000. The government will not tax you on the $150,000 profit you made as long as you’ve followed the criteria to avoid capital gains taxes. While the best plan of action is to speak to a real estate agent or tax person, here are some guidelines.
How to Avoid the Capital Gains Tax
You can typically take advantage of the capital gains tax exemption if you meet three requirements:
1.You’ve owned the home you’re selling for at least two years.
2.You’ve lived in the house as your primary residence for at least two years of a five-year period, even if the two years you lived there weren’t consecutive.
3.You haven’t sold another property and claimed the $250,000 or $500,00 tax exemption in the last two years.
If you are disabled, in the military, or affiliated with any other government protection service, you may be able eligible to avoid the capital gains tax, as well.
If you don’t meet the above requirements and your property isn’t exempt from the capital gains tax, here are a few strategies to minimize or reduce it:
Keep the receipts for your home improvements to use toward exemptions so you don’t miss out on claiming all value you added to your house while living there. You’ll need records and receipts when submitting your taxes.
Turn your primary residence into a rental, which will provide a way to cover your mortgage while you live elsewhere. To be exempt from the capital gains tax, however, you’ll need to limit how long you rent it. After three years, it’s considered an investment property.
Investors can also look to Tax Code Section 1031 to profit on business or investment properties without paying capital gains tax. This tax code allows you to trade “like-kind” properties to avoid paying taxes on the initial profit.
Lastly, you can move into your investment property. If you live in your property for at least two years, it changes the nature of your property from an investment property back to your primary residence. You’re then eligible for the capital gains tax exemption.
To learn more about avoiding the capital gains tax or for assistance selling your home, please call PPS House Buyers at 281-306-5055 or fill out our simple online form.