Let me start off by saying that I am not offering financial advice, nor am I a financial advisor. This article is simply opinion, and you should always consult your financial and/or tax advisor before making any decisions.
What are Capital Gains?
As property values in Utah have been skyrocketing over the past 4 years most home owners have seen their homes increase in value anywhere between 24% to as much as 125%. As such, there are many people who are contemplating the sale of their home to cash out and reinvest. With that in mind, I have been approached about the topic of Capital Gains Taxes in many conversations, and in almost every occasion, I see a blank look as their eyes slowly glaze over and they wait for the answer. Is it fear, is it the memory of the 10th grade Algebra/Trigonometry class or is it simply anger over the tax man taking a piece of your hard-earned money and profits on your great investment? Simply put, Capital Gains are any profit you make when selling a property – whether it be a primary residence or any investment property. The fear is real, but understanding how capital gains apply to the sale of your home is crucial and by playing your cards correctly, you could even be eligible to be excluded from the tax upon the sale of your home.
Two Types of Capital Gains
Long Term Capital Gains refer to a tax on profits from the sale of an asset held for more than a year. Long-term capital gains tax rates for 2022 are 0%, 15% or 20% depending on your taxable income and filing status. They are generally lower than short-term capital gains tax rates.
Short Term Capital Gains refer to a tax on profits from the sale of an asset held for less than a year. They are taxed as ordinary income and you will pay ordinary income tax rates in 2022 of 10%, 12%, 22%, 24%, 32%, 35%, or 37% depending on your taxable income and filing status.
Taxable capital gains for one year are reduced by the total capital losses incurred in the year. Capital losses occur when you sell an asset for less than the sales price. Long term capital gains minus any capital losses are known as the net capital gain which becomes the amount on which your capital gains taxes will be assessed.
How Can I Avoid Capital Gains on Real Estate?
If you sell a primary residence you can be exempt from Capital Gains taxes if you live in the property 2 of the last 5 years. There is an exemption of up to $250,000 if you are single or $500,000 for a married couple. If you sell rental or investment property, you can avoid capital gains and depreciation recapture taxes by rolling the proceeds of your sale into a similar type of investment within 180 days, this is called a 1031 Tax Exchange after the tax code. Check out my article Will My Real Estate Investment Make Money for more details on 1031 Exchanges.
Example of Capital Gains: Let's say you purchase a home for $500,000 as a primary residence and live in it 2 of the last 5 years. Then you sell the home for $1,000,000. That leaves you $500,000 in profit from the home (minus real estate commissions, etc.....). If you are married, then you wouldn't have any taxable income because of the $500,000 exemption but as a single person you could have up to $250,000 in taxable income (the first $250,000 of profit is exempt while the additional $250,000 could be taxable). Keep in mind that any improvements to the home as well as real estate commissions can also be added to your cost basis and would be exempt for capital gains tax.
To qualify for the Real Estate Capital Tax Deduction, you must meet the following requirements:
1- You must live in the home for two of the past five years.
2- The home must be your primary residence.
3- There are special exemptions for military personnel – check them out here.
4- If your spouse passes away.
Are There Other Ways to Reduce Your Capital Gains Tax?
I am going to reiterate the fact that you need to consult a tax advisor for details on how to reduce and calculate your tax liability.
Another crucial point to understand about capital gains when it comes to real estate is to consider how to calculate your exclusions. This is so critical because the profit you take from the sale of your home is what is taxed. What that means is you need to look at what you paid for the home, plus any capital improvements you made as these can contribute to your adjusted basis to bring down your capital gain tax. My advice – keep detailed records for any improvements you make on your home! Remember, these are not simply repairs, they are legitimate improvements. You can learn about the difference as it relates to taxes in this article by NOLO.com. A great example to distinguish between repairs that are not tax deductible and those that are would be fixing a broken window vs installing new replacement windows. If there is ever a question, you can refer to your receipts so that your tax professional can correctly advise you. Remember, even if you do not live in the home for two full years, you can still use exclusions to offset taxes and protect your profit and you could be eligible for a portion of the exclusion.
Hire Me to Be Your Realtor!
Although Realtors are not tax professionals, we are home selling professionals. I have had multiple clients who have hired me to sell their home and I advised them to wait as long as 6 months so that they could qualify for the capital gains exemptions. This saved them tens of thousands of dollars!
Understanding the capital gains tax on your home is vital to protecting your investment. No one should pay more taxes than they have to. If you have any questions or need a referral to qualified tax professionals, please contact me at brandonrwood19@gmail.com or 801-885-2558.