Regardless of whether you completed various higher-return renovations following moving into your new piece of real estate or you have been lucky enough to move into an area proper prior to the upswing in residence values, walking away with a profit on your household sale is an exciting proposition. But there’s one thing that can suck the excitement right out of such a good financial move: the threat of taxes on your investment gain — otherwise known as the dreaded capital gains tax.
Fortunately, the Taxpayer Relief Act of 1997 helps quite a few property owners hold on to the gains earned on their residence sale. Pre-1997, home owners could only use a once-in-a-lifetime tax exemption of up to $125,000 on a dwelling sale, or they would have to have to roll their earnings into the purchase of yet another house. These days the guidelines aren’t as stringent. As with all tax-connected factors, there are plenty of exceptions and loopholes to be aware of. So let’s break down a few misconceptions about capital gains and household sales.
Tax therapy: Home flippers vs. property owners
One prevalent misconception when it comes to capital gains tax on real estate is that all residence sales are treated equally. However for property flippers, that’s simply not the case. To acquire the best tax treatment on your gains, you will have to have applied the dwelling as your principal residence for two out of the 5 years preceding the sale. If the household was not used as a primary residence for the allotted time, profit on the sale is taxed as capital gains. Even so, for those who flip houses on an ongoing basis, homes are considered inventory as an alternative of capital assets, and the profit earned is taxed as income. Long-term capital gains tax is 15% for most persons, 20% for those in the prime tax brackets. Even so, if the gains are taxed as income, rates could vary from 10% to 39.6% based on the rest of your income. In addition, house flippers aren’t allowed to simply steer clear of the tax by rolling earnings over into their next property purchase.
Exemption limits: Filing married vs. single
Even though the Taxpayer Relief Act did away with the once-in-a-lifetime tax exemption of $125,000, exemption limits haven’t absolutely fallen by the wayside. Now you can pocket up to $500,000 of every household sale profit tax-no cost if you’re married, or up to $250,000 if you’re single. But for some newly married couples, claiming this exemption can be a bit tricky. If a single individual owned the home for the previous two years, but their companion wasn’t added to the title till, say, the final two months, that’s OK. However, each parties need to have lived in the residence for two years prior to the sale — even if only one person was on the title before were married. In addition, if one particular person sold a previous residence within the last two years and cashed in on an exemption, the couple will have to wait until they are both out of that two-year window ahead of pocketing any gains from their shared property.
Type of home: Primary residence vs. vacation home or rental property
If you aren’t flipping homes, but you do have a second home or a rental property you’d like to sell after living there for the required two years, it won’t be treated as a primary residence for tax purposes. Second homes and rental homes no longer receive the same tax shelter they did before a 2008 shift in the tax code — even if the home becomes your primary residence for a time. Instead, when tax time comes around, you will owe a prorated amount based on the number of years the property was rented out or used as a second home after 2008. If, for instance, you used your vacation home as your primary residence for five years starting in 2010, but you used it as a vacation home for 15 years before that, only 10% of the gains would be taxed: The two years post-2008 when it was used as a vacation home equals 10% of the total 20 years of homeownership. The rest of the profit wouldn’t be taxed as long as it fell within the exemption limits.
Profit: Large sale price vs. small sale price
Another common misconception is that the more a home sells for, the larger the tax bill will be. However, for tax purposes, what you owe doesn’t depend on the sale price — it’s based on how much profit you make from the sale. In fact, you could sell your home for $5 million and not owe a penny in taxes — as long as you didn’t make more than the allowed exemption amount on the sale.
Another important thing to note: Capital gains tax on real estate isn’t necessarily an all-or-nothing proposition. If you’re nearing the cap on exemptions, you could still qualify for a partial exemption — just be sure to consult a tax professional before you make any big moves.
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