When you own assets, such as property, you may receive a profit from them. Capital gains tax is the tax that the government charges when you make a profit from selling your real estate.
In essence, capital gains is the profit you made from the sale of your property. A capital gains profit is the difference between the price you initially bought the property for and the price you sold it for minus some deductible expenses.
Examples of some deductible expenses are: advertising, 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 don’t physically affect the property, they are probably deductible. These costs are usually listed in the closing statement prepared by the bank, escrow, or attorney in some states when you sell your house.
Capital gains taxes can also apply to investments, such as stocks, bonds, and tangible assets like cars, boats, and other motor vehicles. Also, there is no effect of capital losses on your income tax, meaning you do not receive a tax deduction if you lose money from the sale of your property.
As noted above, one major way of reducing your capital gains tax is to factor in your deductible expenses. There are three main types of expenses:
- Capital Improvements Deductions: You are allowed to subtract the cost of capital improvements you have made to your property. Capital improvements are improvements that add value to property or prolong its usefulness; capital improvements are not repairs from normal wear and tear.
- For example, replacing dirty carpet with new carpet is not a capital improvement; however, adding a bedroom, bathroom, deck, built-in appliances, or improvements to a home’s exterior, such as replacing the roof, are examples of capital improvements.
- Sale Cost Deductions: These are the deductible expenses that are incurred in the sale of the property. Examples of these expenses were mentioned above and include legal expenses and real estate agent’s commission.
- Other Exemptions: You should also apply every exemption possible to reduce your capital gains. Other exemptions include owning your property for over a year, and selling your house after residing in it for at least two of the past five years you’ve owned it.
- Further, 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 . Thus, you do not need to pay any tax on that amount of profit from the sale, but if the profit exceeds the amount excludable, then you must pay tax on the overage.
Finally, if you don’t qualify for the home sales tax exclusions, you have to pay taxes on the entire gain minus the above deductions. For example, 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, then the entirety of that gain might not be subject to the capital gains tax; however if you are single then $250,000 of the gain is subject to capital gains tax minus other deductible expenses. It is important to keep track of your expenses, as doing so can save you a considerable amount of money.
A 1031 exchange is essentially you swapping a property for another property within a 6-months period. Thanks to 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 they just sold.
A properly structured 1031 exchange is not an easy matter. In order to take full advantage of the 1031 exchange, you should contact a real estate law firm within 45 days of the sale, as you will need to file a list of properties you want to swap with. Then at the 6 month mark, you must buy a new property, otherwise you will owe the original capital gains tax due on the property that you sold.
Although hiring an attorney is not necessary for the sale of your home, having an experienced and well-qualified real estate attorney in your corner to help you understand if you qualify to exclude capital gain from the sale of your home.
Further for certain activities, such as doing a 1031 exchange, the law requires that you use a real estate lawyer. As such, it may be in your best interest to have an attorney to consult with throughout the entire process of selling your property and assets.