When you sell an investment asset, be it a stock or real estate, it’s often the case you do so to realize a profit. However, that margin is lessened by the capital gains tax, something of a surcharge for your smart money management. Essentially, it’s a penalty on profit and can easily wipe away most or all of your gains when you sell. It applies to things like stocks and real estate and presents a scenario that most property investors would like to avoid.
Depending on your income tax bracket and the value of the real estate property you sell, not to mention the property type, capital gains tax can range from a very non-issue of zero percent, up to a costly 20 percent. Time is also factored into the calculation, if you haven’t owned the property very long, you may be able to avoid having to pay capital gains. However, if you have owned the real estate parcel for some time, you’re not likely to escape it without having to go through a loophole.
The capital gains tax, like so many others, is one that incentivizes clever workarounds. The same federal agency which collects this particular tax does provide some ways to get out of paying it. This is welcome news for real estate property investors, who can use different techniques to keep their gains, in whole or in part. With April fast approaching, you’ll need to take action so you aren’t caught in a hefty tax situation.
CAPITAL GAINS AND YOUR PRIMARY HOME
The Internal Revenue Service levies its capital gains tax on investment assets when these are sold. However, your primary residence is able to escape paying this tax, that is, if it’s less than $250,000 for you as an individual or as much as $500,000 if you’re married and file jointly. To be able to claim an exclusion, you must meet three criteria: it is your primary residence, something easy to prove with the Florida homestead exemption, you must have owned it for two years or more, and have lived in the house for at least two of the past five years.
“Capital gains taxes are charged when you sell something that’s increased in value such as an investment like a stock or property. If you held onto the asset for more than a year before you sold it, then you are taxed on a long-term capital gain at a tax rate of 0% to 20%.” —Realtor.com
Should you not meet these requirements when you sell your real estate property, you are tax according to your personal income bracket. If you are in the brackets between 10 percent and 15 percent, your capital gains tax is zero. Those who are in the 25 percent to 35 percent income tax bracket are subject to pay a capital gains tax of 15 percent. Should you be in the highest income bracket, 39.6 percent, your capital gains tax will be 20 percent.
HOW TO AVOID PAYING CAPITAL GAINS TAX
Since this penalty is so stiff, most sellers would like to avoid paying capital gains tax. As mentioned, there are ways to escape the IRS, but you have to do a bit of work. Here are some ways to avoid paying capital gains on the sale of real estate:
- Use a 1031 exchange. Sarasota is known for its sub-tropical climate, wonderful weather, and for its many recreational opportunities. This is why owning an investment property is so attractive, because it can be used as a dedicated vacation home, as well as be rented out. That passive income is great, but if you decide to sell it, you’ll be faced with paying capital gains. However, if you use a 1031 exchange, you can avoid the tax by purchasing a similar property within 180 days. You’ll also be able to avoid paying depreciation recapture taxes with a 1031 exchange.
- Claim a stock exchange. For real estate property investors who also have a hefty securities portfolio, the stock exchange works much like a 1031 exchange, but won’t necessarily reduce your tax burden to nothing. You can exchange highly appreciated securities to lessen your tax obligation. Though this strategy isn’t cheap, it’s often quite a bit less than paying capital gains on the sale of your investment property.
- Deduct home improvements. Another way to avoid capital gains, or lessen the penalty, is to deduct the money you’ve spent over the years on home improvements. An example would be you purchased your investment property for $250,000, and are now selling it for $325,000 because its appreciated. However, you’ve spent $30,000 on home improvements. That money can be deducted from your tax liability, adjusting your gains down to $295,000.
If none of these really suits your needs, then you can just opt to hold onto the property and leave it to heirs. This way, the beneficiaries are allowed to claim a step-up in cost basis, which adjusts the value to the market rate at the time of inheritance, not when the property was first purchased.