There are so many perks to homeownership, including certain tax breaks. For instance, if you own a home, you may be eligible to deduct interest expenses on up to $750,000 of mortgage debt, which can save you some cash come tax time.
But there may be certain taxes that you may actually have to dish out when you sell real estate, depending on your particular situation.
They’re called capital gains taxes, and they may be payable when a piece of property changes ownership.
If you turn a profit when you sell your property, you’re said to have realized “capital gains,” which basically refers to the profit made on the sale of your home. For instance, if you bought your home for $500,000 seven years ago and sell it for $750,000 today, you’ll have profited $250,000.
If you sell for more than what you paid for it, you’re obligated to report these gain to the IRS, who will then tax you on those capital gains. Depending on your situation and the status of your home, there may be taxes to be paid on that profit, or “capital gains taxes.”
But as pesky as capital gains may sound, they might not necessarily be applicable to you, as long as you and your property meet specific criteria. But how do you know if you’re subject to these taxes when you sell your home for more than what you paid for it?
Capital Gains Tax Exemptions
Luckily, there are certain situations in which you may be able to get away without having to pay capital gains taxes on any profit you make on the sale of your home.
The first $250,000 is exempt, with exceptions. You don’t have to pay any capital gains taxes on the first $250,000 that you profit from the sale of your home if you’re single, or $500,000 if you’re married. However, you and your home will have to meet the following requirements.
You owned your home for at least two years. If you’re an investor who fixes and flips properties for a profit, you’ll find that you’ll be subject to capital gains taxes on any gains you make.
That’s because the home must have been in your possession for at least two years. So, if you fix and flip the property only a few months after buying it, short-term capital gains taxes will be applicable.
You lived in the home for at least two years. Not only does your name have to have been on title for at least two years, you must have called the home your primary residence for at least two years as well.
You don’t necessarily have to have lived there for two consecutive years, but the place must have been considered your primary home in order to be exempt from paying capital gains taxes. More specifically, you must have lived there for at least two of the past five years.
You haven’t claimed exemption within the past two years. You’re only allowed to take advantage of capital gains tax exemption once every two years. However, you can take advantage of this exemption over and over again without limit, as long as it’s not repeated any more often than every couple of years.
A Word About 1031 Exchanges
If you’re a real estate investor and are concerned about the prospect of having to dish out a lot of money on capital gains taxes on your profits, you might have a way to avoid having to pay capital gains taxes thanks to something called a “1031 exchange.”
As per IRC Section 1031, a 1031 exchange allows investors to sell a property and reinvest the proceeds of the sale to purchase another property. While this is a simplified explanation of what a 1031 exchange is, it’s a great way for investors to hold onto their gains and use them to continue investing in real estate and grow their wealth without having to constantly pay up every time a property is sold at a profit.
Short- Vs Long-Term Capital Gains
If you are required to pay capital gains, you will want to know if you’ll be subject to short- or long-term gains, as this will affect how you’re actually taxed.
Short-term gains apply to homes that are owned for less than one year. In this case, the rate is equivalent to your tax bracket. Long-term gains apply to homes that are owned for at least one year. And while long-term gains are typically taxed lower than short-term gains, the exact amount of taxes you have to pay will depend on your income.
People with higher incomes could pay as much as 15% to 20%, while those with a more limited income might not owe anything at all.
The Bottom Line
No one likes to pay taxes, but if you get familiar with how the IRS taxes home sellers and play your cards right, you may be able to avoid paying capital gains taxes when you sell. Be sure to discuss your particular situation with a tax specialist to find out where you stand as far as capital gains taxes are concerned.