Selling Your Home? Important Things to Know About Capital Gains Tax
New homeowners quickly learn they have many tax considerations to factor into their budgets, especially regarding property and school taxes. However, many don't realize there is sometimes a tax to be paid when a home is sold. This tax, known as a "capital gains" tax, can take a large chunk of the profit on the sale of any of the types of real estate investments. Planning for capital gains taxes should start years before a home is put on the market. Keep reading to find out the most important things you can know about capital gains tax.
What is Capital Gains Tax?
If a homeowner sells their home at a higher price than what they paid for it, they may fall under a mandatory rule requiring them to pay capital gains on the profit. For many people, this is a non-issue, especially if property values are in the same ballpark range. However, owners who purchased their homes many years ago or when home prices were much lower than at the time of sale may be required to pay the tax, depending on the tax bracket they fall under.
Example: A single taxpayer bought a property in 1982 for $70,000 in a quiet neighborhood. Since that time, the area was built up, employers set roots, and the population has grown. Currently, the area is in high demand, and property values have soared. The same house is now worth $370,000. The $300,000 in capital gains would be subject to tax in this case.
How Does the IRS Calculate Capital Gains Tax?
The IRS designates capital gains tax at 0%, 15%, or 20%. For most people, this tax is no higher than 15%, according to the federal tax agency. Individuals with annual taxable income of less than $80,000 are likely to be taxed at 0% of the capital gain from the sale of their home. However, individual circumstances will ultimately dictate if a capital gains tax applies, depending on:
- Tax filing status (single or joint filer)
- Amount of taxable income
- Homeowners don't meet the "use test" due to potential capital gains tax exclusions
The IRS outlines other criteria on its website. It's essential to keep in mind any tax rules set by the IRS are always subject to change. Homeowners should always check the latest criteria to see if capital gains taxes apply to them. People should also note that capital gains taxes will only be applied to the first $250,000 (or $500,000 if filing jointly). However, this tax break is only available once every two years, making it catered more towards standard owners rather than high-volume property investors.
How to Reduce Capital Gains Taxes When Selling Property
People standing to make a considerable profit when they sell their homes can take proactive steps to reduce the amount they'd ordinarily be required to pay in capital gains taxes. However, this takes strategic planning long before the property is listed on the housing market.
- Plan to own the property for at least two years because any shorter length of time designates the sale as "short-term capital gains" and thereby taxed at a higher rate than "long-term capital gains" would.
- Use the home as a primary residence for at least two of the previous five years to avoid being required to be taxed as an income-generating secondary home, rendering it ineligible for capital gains exemptions. Note: The 2-year period doesn't have to be consecutive.
- Maintain records and receipts of any money spent on improvements during ownership because specific improvements that raise the home's value can be deducted with proper documentation. Note: Improvements don't necessarily need to be new.
- Keep records of money spent on marketing and selling a home, including advertising costs, real estate fees, closing costs, and any other expenses incurred while selling a home.
- Exclusions may be eligible for military service members, people with disabilities, and foreign service or intelligence community members. IRS Publication 523 offers more eligibility information.
Generally, properties solely used as investment property are not eligible to be excluded from capital gains taxes.
Are You Preparing For Capital Gains Taxes?
All homeowners need to understand what capital gains taxes are and when they apply. Selling property can be a complicated process. Connecting with an experienced financial expert can help you navigate any tricky situations or offer a referral to another trusted professional to help. With proper planning, anyone can easily handle capital gains taxes and enjoy the benefits of their high-ROI home improvements.