When you sell an asset for a profit, it's known as a capital gain. This is true when you sell a stock for more than you paid, sell real estate for a profit, and most other situations where you sell something and come out ahead.
Capital gains are taxable, but not all gains are treated the same for tax purposes. The time period you owned it before selling makes a difference. And there are a couple of big exclusions that could lower your tax liability for real estate capital gains.
We’ll go over what real estate investors need to know about capital gains taxes and what you can do to get out of paying them.
Capital gains tax rates
There are two kinds of capital gains taxes. Short-term capital gains occur when you held an asset for a year or less. These are taxed in the same way as ordinary income. If you own a property for a few months and sell it at a profit, it's a short-term gain and is taxed at your marginal tax rate (tax bracket).
If you sell an asset you held for more than a year, any profit is considered a long-term capital gain. This is quite common in real estate. Long-term gains have their own tax brackets and are generally taxed at lower rates than ordinary income and short-term gains.
The income thresholds change annually to keep up with inflation, but here’s a quick guide to the long-term capital gains tax brackets for 2019:
|Long-Term Capital Gains Tax Rate||Single Filers (Taxable Income)||Married Filing Jointly||Heads of Household||Married Filing Separately|
|0%||$0 - $39,375||$0 - $78,750||$0 - $52,750||$0 - $39,375|
|15%||$39,376 - $434,550||$78,751 - $488,850||$0 - $461,700||$39,376 - $244,425|
|20%||Over $434,550||Over $488,850||Over $461,700||Over $244,425|
Besides the rates listed in the table, higher-income taxpayers may also have to pay an additional 3.8% net investment income tax.
What is your cost basis?
In this discussion, profit is the difference between the sale price of a property and your cost basis. This is important: Your cost basis and the price you paid for the property can be different.
Be sure to include the purchase price and other expenses from acquiring the property. As an example, legal expenses you paid at closing should be included in your cost basis.
Also add the cost of major improvements. If you put an addition on the property, added a swimming pool, or renovated the kitchen, add the price to your cost basis.
Let’s say you paid $200,000 for your home and paid $3,000 in various expenses when you bought it. A year later, you spent $20,000 adding a swimming pool and $15,000 adding a garage. Your cost basis in the property would be $238,000.
One big exception is when you inherit a property. Whenever you inherit a capital asset, your cost basis is the asset’s fair market value at the date of death. In other words, if your parent paid $20,000 for their home in the 1950s and left it to you in 2018 when it was worth $300,000, the latter amount would be your cost basis.
With rental properties, there’s another potential tax issue. Each year, owners of rental real estate can claim a depreciation expense to lower their taxable income. The downside is that the depreciation also lowers the cost basis in the property. When a rental property is sold, the owner must pay the tax benefits of depreciation back to the IRS. This process is known as depreciation recapture.
Imagine you bought a rental property with a depreciable value of $200,000. You can take a depreciation expense of $7,273 per year. This is a big benefit on a year-to-year basis, but it really adds up over time. If you sell the property after 10 years, for example, you’d have nearly $73,000 worth of taxable depreciation recapture.
Two big exceptions
While profits from the sale of real estate are capital gains, there are a couple of big exceptions you should know about. The first is a special rule that allows you to exclude a certain amount of profit when selling a primary residence. The other is a way to defer capital gains taxes when you sell an investment property.
The primary residence exclusion
If you have a capital gain that results from the sale of your main home, the primary residence exclusion could help you avoid capital gains taxes.
In a nutshell, you can exclude as much as $250,000 of capital gains from your income. If you file a joint tax return with your spouse, the exclusion cap is doubled to $500,000. To qualify, the sale needs to meet two criteria:
- You must have owned the home for at least two out of the five years before the sale.
- You must have used the home as your main home for at least two of the five years before the sale.
These don’t need to happen during the same two years. For example, if you lived in a home owned by your parents for two years, then purchased it and sold it two years later, it could qualify. But you can’t use the exclusion if you excluded the gain from another home during the two-year period prior to the sale.
1031 exchange: A real estate investor’s best friend
What about for investors? Because you pay taxes on both the profit from the sale and for depreciation recapture, you can get a massive tax bill when you sell an investment property.
Fortunately, there’s a way to get out of paying any taxes on the sale of investment properties: A 1031 exchange.
There’s a lot you should know before attempting to complete a 1031 exchange, so be sure to check out our main page on the subject. Here's the main idea:
A 1031 exchange (or "like-kind exchange") lets you defer taxes on the sale of an investment property by using the proceeds to buy another property. As long as you use the proceeds to re-invest, you can defer taxes on investment properties indefinitely.
You must buy the new property for at least as much as the other one sold for, or else you may have to pay capital gains tax on the difference. And you must carry as much or more financing as the original property. In other words, if you sell a property for $500,000 that had a $300,000 mortgage, your newly-acquired property must have an equal or greater purchase price and loan amount. Also, there’s a time limit -- you need to identify potential properties to buy within 45 days of the sale and close on the new property within 180 days.
Ask a professional if you aren’t sure
Capital gains taxes can be more complicated with real estate than with the sale of other assets and this creates more gray area. For example, it might be unclear if your personal residence meets the ownership and use tests for the exclusion. If you aren’t sure about any tax issues or exclusions, seek guidance from a tax attorney or other tax professional before filing your return.