A capital gain occurs when a person who holds a capital asset “makes money” on the sale of that asset. An example of this would be how a person may purchase a piece of empty land, the price of which at the time of purchase is $100,000.00. They purchase the land hoping that future developments or time will make the land more valuable. When they sell the land, they receive more money for the sale than what they initially paid.
To continue this example, suppose that after a few years oil is found under the land. As a result of the oil finding, the property value rose from $100,000 to $600,000. If and when the owner sells the property at this higher value of $600,000, they have realized a capital gain. The amount of the capital gain equals the increased price, minus the purchase price; or, $600,000-$100,000, so that the amount of the capital gain is $500,000.
The Internal Revenue Code is the law that determines:
- Who must pay taxes;
- When taxes must be paid; and
- The rate of taxation.
The IRC requires that people pay taxes on capital gains. The capital gains tax rate largely depends upon whether the capital gains are long-term, or short-term gains.
Generally speaking, the Internal Revenue Service (“IRS”) which administers the tax code, considers assets that are held for one year or less before being sold to be “short-term assets.” The one year begins on the day after the capital was purchased, and stops on the date of sale. Additionally, the capital gains tax rate for short-term gains is the amount at which an individual’s ordinary income is taxed. This amount is referred to as an individual’s tax bracket.
As of 2020, there are seven ordinary income tax brackets:
- 10 percent;
- 12 percent;
- 22 percent;
- 24 percent;
- 32 percent;
- 35 percent; and
- 37 percent.
Taxation in the United States is said to be progressive; meaning, the greater a person’s income, the higher percent at which that income is taxed.
An example of this would be how the initial $9,875 of the income of an individual who earns $600,000, is taxed at 10%. Once they have earned $40,126, the income between $40,126 and $8,2525 is taxed at 22%.
The tax rate for each additional margin, or amount of income increases. Once a person has earned $518,400, all income above that amount is charged at 37%. A person’s highest tax percentage, which here is 37%, is the individual’s tax bracket. Short-term capital gains income is taxed at the rate of that bracket. An example of this would be how in the case of the person who has already earned $600,000, a short-term capital gain of $2,000 is taxed at the 37% rate.
To further illustrate the difference between short term and long term capital assets, long term capital assets are held for more than one year before they are sold. The amount of capital gain on long-term capital assets is subject to capital gains tax, although the general long-term capital gains tax rate can be one of three numbers:
The rate largely depends on a person’s taxable income and filing status, such as whether they are single or married. To summarize, long-term capital gains are generally taxed at a lower rate than short-term capital gains.
What Is Capital Gains Tax For Real Estate Sales?
To reiterate, capital gains tax is the tax that the government charges when you make a profit from selling your real estate. In short, capital gains is the profit you made from the sale of your property. A capital gains profit is the difference between the price that you initially bought the property for, and the price that you sold it for minus some deductible expenses.
Some of the most common examples of deductible expenses include:
- Appraisal fees;
- Closing fees;
- Document preparation fees;
- Notary fees;
- Mortgage satisfaction fees;
- Real estate broker’s commission;
- Recording fees;
- Title search fees; and
- Attorney fees.
Essentially, if the expenses do not physically affect the property, they are most likely deductible. Such costs are generally included in the closing statement that is prepared by the bank, escrow, or attorney.
Capital gains taxes can also apply to investments, such as:
- Bonds; and
- Tangible assets such as cars, boats, and other motor vehicles.
Additionally, there is no effect of capital losses on your income tax. What this means is that you do not receive a tax deduction if you lose money from the sale of your property.
How Can I Calculate And Reduce My Capital Gains Tax?
A significant way to reduce your capital gains tax is to factor in your deductible expenses. There are three types of expenses:
- Capital Improvements Deductions: You may subtract the cost of capital improvements that you have made to your property. Capital improvements are improvements that add value to property or prolong its usefulness; it is important to note that capital improvements are not repairs from normal wear and tear;
- Sale Cost Deductions: These are the deductible expenses that are incurred in the sale of the property, as were previously detailed; and
- Other Exemptions: Other exemptions include owning your property for over one year, and selling your house after residing in it for at least two of the past five years that you have owned it. Additionally, most people who sell their personal residences qualify for a home sales tax exclusion of $250,000 for single homeowners, and $500,000 for married couples who file jointly.
If you do not qualify for the home sales tax exclusions, you must pay taxes on the entire gain, minus the above deductions. An example of this would be how if you purchased a home seven years ago for $150,000 and sold it today for $650,000, you would make a profit of $500,000.If you are married and file your taxes jointly, the entirety of that gain might not be subject to the capital gains tax; however if you are single, $250,000 of the gain is subject to capital gains tax, minus other deductible expenses.
Can I Do A 1031 Exchange Instead Of Paying Capital Gains Tax?
A 1031 exchange essentially involves swapping one property for another property within a period of six months. Because of IRC section 1031, an investor who re-invests the proceeds of the sale of their property in a new property does not need to pay capital gains tax, if the equity in the new property is at least as much as in the property that they just sold.
In order to take full advantage of the 1031 exchange, you would need to contact a real estate law firm within 45 days of the sale, as you must file a list of properties you would like to swap with. At the six month mark, you must buy a new property, otherwise you will owe the original capital gains tax due on the property that you sold.
Do I Need An Attorney For Capital Gains Tax For Real Estate Sales?
If you have any questions regarding capital gains tax for real estate sales, you should consult with an experienced and local tax attorney. Certain activities, such as doing a 1031 exchange, are required by law to utilize legal representation.
Additionally, a local lawyer will be best suited to helping you understand your legal rights and options according to your state’s specific laws. Finally, an attorney will also be able to represent you in court, as needed.