Depending on the circumstances surrounding the sale of your property, you could wind up having to pay capital gains taxes to Uncle Sam come tax time.
A capital gain is the profit you make when selling real estate after deducting the costs associated with the sale – such as real estate commissions, legal fees, or costs associated with making necessary improvements. Capital gains are typically taxable, though the rate at which they are taxed depends on a few factors.
Let’s dive into capital gains and how they are taxed into a little more detail.
How Long You’ve Held Onto the Property Affects Your Tax Rate
The IRS taxes capital gains based on whether they’re classified as short-term or long-term. If you sell a property after owning it for less than one year, this will be considered a short-term investment and any gains you make will be taxed as regular income. On the other hand, if you’ve owned the property for at least one year and a day, this will be considered long-term and your profits will be taxed as much as 20% depending on your tax bracket. For the majority of people, however, it’s 15%.
In addition, you’ll have to pay state income taxes on your capital gains income, and in California, that rate is 13.3% – the highest in the country.
Factor Depreciation Into the Equation
If this is an investment property that you ‘depreciated’ after wear and tear over the years, you might have to recapture some of that amount when you sell. As such, you’ll need to pay state and federal taxes at your marginal rate.
The IRS will expect depreciation to be calculated when you sell an investment property, so you should make sure you take advantage of depreciation while you still own the property. You can depreciate the actual structure of the property, as well as any additional capital investments you made to improve the place.
You’ll be limited to a certain time period to deduct depreciable assets, which is 27.5 years for residential properties versus 39 years for commercial properties. The amount that your annual net income would be reduced by after taking into account your depreciable assets can be calculated using a simple straight line of depreciation method.
In the case of a residential property that costs $200,000, for instance, you would realize a yearly deduction of $7,272 ($300,000 ÷ 27.5). At tax time, your annual net income would be decreased by $7,272, which effectively lowers the amount of taxes the IRS would take.
In addition to the structure itself, you can also depreciate things such as appliances, HVAC systems, electrical and plumbing systems, landscaping, new roof, new windows, equipment to maintain the property, legal fees, and so forth. Items like these have a much shorter depreciation period compared to the structure, which can range from five to seven years depending on the specific item or system.
It should be noted that you can’t depreciate any repair costs or service contracts, which can only be deducted as expenses from your net income. In addition, you can’t depreciate the land that the home sits on as it’s not considered a depreciable asset.
The depreciation process is certainly much more complex than this. You’ll want to speak with your accountant or bookkeeper about exactly how much you owe the government in taxes when factoring in depreciation over the course of time that you owned the property.
Adjust the Basis to Calculate Your Capital Gains
The price that you originally paid for the property will serve as the “basis” that will be factored into the calculation of capital gains made. Any improvements made on the property will create what’s referred to as an “adjusted basis,” which includes the money spent on the purchase price as well as the money spent on making improvements. If your purchase price was $300,000, for instance, and you spent $50,000 on sprucing up the place, your basis will then be adjusted to $350,000.
This number would then be subtracted from the sale price to determine your capital gains. If you sold the property for $400,000, your gains would work out to $50,000. However, you can lower this amount after factoring in the costs associated with selling the property. The number you wind up with is what you’ll have to pay taxes on.
Can You Avoid Paying Capital Gains Taxes?
Most people would agree that if there were ways to minimize the amount of taxes paid on profits made from selling real estate, they would take advantage of them. The good news is, there actually are legitimate ways to avoid paying capital gains taxes.
For starters, you can do what’s known as a 1031 exchange which would allow you to defer paying capital gains taxes on your investment property when you sell it. In this case, you would have to use the proceeds of the sale of your current investment property to be put towards the purchase of another investment property, as long as it’s of equal or lesser value.
Another way to avoid having to pay capital gains taxes is to convert the property into your primary residence, as long as it’s a single-family home. You would also have to live in the home for at least two out of five years in order for it to be qualified as a primary residence, but you don’t actually have to be living there at the time of the sale. If you’re single, you’re allowed to exclude the first $250,000 in capital gains from federal taxes, and if you’re married, you can exclude $500,000 in gains.
The Bottom Line
Taxes paid on capital gains might not necessarily be something that you would think twice about when selling your family home. However, if you plan on buying and selling real estate for investment purposes, it’s crucial that you understand how capital gains taxes work in order for you to be able to gauge how profitable every transaction that you make will be.