Real estate investments are often touted as one of the best ways to both build your wealth and realize a return on your investments. Unfortunately, while the rewards can be great, the taxes associated with real estate investments can also be substantial. When it comes to selling a property, capital gains taxes need to be taken into account. To maximize profit, real estate investors should be aware of all strategies and methods available to reduce their liability.
Calculating Capital Gains Taxes
When a capital asset like a home is sold, the capital gains must be reported to the IRS. Capital gains taxes are calculated by subtracting the purchase or adjusted basis of the asset from the sale price. The adjusted basis is a calculated value that includes the purchase price, costs associated with improvements to the asset, and any fees resulting from the sale of the property like commissions or closing costs.
For the purpose of calculating capital gains taxes, short-term capital gains are those generated from an asset that is owned for less than a year, while long-term capital gains are the gains made from an asset that is held for longer than a year. Short-term capital gains are taxed at the same rate as ordinary income while long-term capital gains receive special tax treatment.
Strategies for Reducing Capital Gains
Taxpayers have several strategies in their arsenal to reduce capital gains taxes. The first and most common strategy is to simply hold onto the property for more than a year before selling. This is the simplest way to take advantage of the special tax rates applied to long-term capital gains.
Taxpayers can also take advantage of section 1031 of the tax code. This section allows taxpayers to defer paying capital gains taxes on the sale of a qualified property if the proceeds of the sale are reinvested into another similar asset.
Another strategy is to take advantage of the capital gains tax exclusion. This exclusion allows individuals to exempt up to $250,000 of capital gains from being taxed, or $500,000 for couples who file a joint return.
Finally, tax deductions and credits can also be used to reduce capital gains taxes. Taxpayers who hold properties for more than two years can take advantage of the First-Time Homebuyers Tax Credit which can result in significant savings on capital gains taxes.
Capital gains taxes can put a dent in the profits earned from a real estate investment, but there are several strategies available to reduce the liability. By taking advantage of strategies like holding onto an asset for more than a year, taking advantage of section 1031 of the tax code, using the capital gains exclusion, or taking advantage of available deductions and credits, real estate investors can maximize their profits and minimize their liability.
Overview of Capital Gains Tax on Home Sale
Capital gains tax is a tax imposed on the profits that a person earns through a sale of a property, such as a house. When it comes to home sale, the amount of money you receive for the sale of the home then become the profits, and this profit is subject to capital gains tax. The rate of the capital gains tax vary from one state to another and also depends on other factors like one’s tax bracket and the type of assets sold. It is important to note that the IRS (Internal Revenue Service) considers a primary home, such as your residential home, a capital asset.
Section 121 Exclusion
The Section 121 exclusion allows up to $250,000, or up to $500,000 if you are married and filing jointly, to be eligible for a full or partial exclusion from capital gains tax. This means that if you are married and filing jointly and make a net profit of up to $500,000 on the sale of your home in a given tax period, you can exclude the full amount of your net profits from the capital gains tax. However, if you make more than $500,000 on the sale of the home, you will need to pay taxes on the portion that is in excess of $500,000.
What are the Qualifying Criteria?
It is important to note that in order to qualify for the Section 121 exclusion, you must meet certain criteria. First, you must live in your home for at least two out of the last five tax years leading up to the sale of the home. Second, you must not have excluded another home sale in the last two tax years prior to the sale of this home. Finally, you must have not sold a home in the two years prior to the sale of this home and excluded any gain from that sale. If you qualify for the Section 121 exclusion, you can partially or completely exempt your net profits from the capital gains tax. It is important to be aware of the conditions for this section so you can determine if you qualify for the exclusion and determine the amount of capital gains tax you might be subject to when selling your home.
In conclusion, capital gains tax can apply to the profit made from the sale of homes and residential real estate. The Section 121 exclusion, however, allows up to $250,000, or $500,000 if you are married and filing jointly, to be eligible for a full or partial exclusion of capital gains tax. To qualify for the Section 121 exclusion, you must live in the home for two out of the last five tax years leading up to the sale, not have excluded another home sale in the two tax years prior to the sale, and not have sold a home in the two years prior to the sale and excluded any gain from that sale. Knowing the criteria for the Section 121 exclusion can help you determine how much of your net profit from the home sale is excluded from capital gains tax.