Real estate makes an excellent investment because you’re building equity into a stable market. Many commercial investors use it as a generous side income to build wealth for retirement. They lose a little on their taxes, but the remaining profits make it worthwhile.
Commercial investors know that the profits they make on their properties will be taxed according to federal law, but what about when you sell your personal residence? Homeowners profit on their transactions all the time—will Uncle Sam profit too?
There are some cases in which you’ll owe taxes on the profit of your home and others in which you’ll owe nothing. It’s important to understand the tax implications before you sell your home so you’re not blindsided come tax season.
Capital Gains Explained
The primary tax obligations for real estate are called capital gains. These are the taxes you’re required to pay when you sell a home for more than you paid for it. It applies to any property or possession that you’ve had for more than one year and that earns you a profit when sold. Because you’re making money on the transaction, it’s treated as a commercial transaction and is taxed as such.
Capital gains can be separated into two categories: short and long-term. Short-term capital gains apply if you’ve owned the house for less than a year. You’ll owe income taxes based on your ordinary tax bracket if that’s the case.
Long-term capital gains apply if you’ve owned the house for more than a year. The rates are significantly lower in this case, and some homeowners won’t owe anything depending on their income and filing status.
The Exception to Paying Capital Gains
The good news about capital gains is that you don’t always have to pay them, and most homeowners don’t. You can profit up to $250,000 when filing individually or $500,000 when filing jointly or as head of household without paying capital gains as long as you meet the following requirement:
- The home must be your primary residence.
- You must have been the owner for at least two years.
- You must have lived in the home for more than two years over the last five years.
- You can’t have claimed the $250,000 or $500,000 exemption on any other property in the last two years.
This is a pretty simple way to avoid major taxes on your residence, but if you don’t meet those requirements, you’ll owe capital gains tax according to IRS Publication 523.
The Cost of Capital Gains
If you don’t meet the requirements above or you’re making more than $250,000 on your home, you’ll want to calculate what you’ll owe. The actual amount you’ll pay varies based on your income. The latest tax laws put capital gains rates into three categories.
0 %: For those who make less than $39,375 individually or $78,750 for those married filing jointly or filing as head of household, you’ll owe nothing on the profits of your home.
15%: This applies to single filers who earn anywhere between $39,376 and $434,550. Those filing married jointly or as head of household must pay 15 percent if they earn between $78,751 and 488,850.
20%: This is the most you can be taxed, and it applies to those making more than $434,550 for single filers and $488,850 for those filing jointly.
Most states also have a capital gains tax, but because there is no income tax in Texas, you won’t owe anything on top of your federal obligations. This tax break makes Texas a great place to invest in real estate!
Other Ways to Avoid Paying Capital Gains
If you don’t want to pay capital gains and you don’t meet the requirements for an exemption, there are more complex ways to get around it.
- Look for an Exception: Talk to an accountant or comb over IRS Publication 523 to see if you can find an exception to the rule. There are exemptions in there for selling the home based on work, health, or an unforeseeable event such as a death in the family.
- Factor in the Repairs: Anything you’ve spent on repairing or improving your home over the last few years can be subtracted from your profits to reduce your tax obligation. Keep the receipts on any home improvement project—if it’s large enough, you might avoid taxes altogether.
- Exchange or Swap the Property: Many homeowners or commercial real estate investors do a 1031 exchange instead of selling a property in order to avoid capital gains tax. This is a tricky loophole because you have to find someone willing to swap properties with you. However, it’s a great way to avoid a hefty tax.
Reporting the Home Sale on Your Tax Return
Typically, you won’t immediately have the tax taken out of your transaction like the withholdings from your paycheck. You’ll report the profits made on your home in the “income” section of your tax return on a separate line as your wages. The taxes will be calculated here.
Because the taxes will be taken out during tax season, make sure you have extra savings to compensate for the expense. You might not receive the return you’re used to, and you’ll probably owe the IRS money. Use the percentages above to calculate the potential taxes owed so you can be ready at tax season.
Get Expert Advice at Green Residential
Navigating the sale of your home is tricky, whether or not you have to worry about capital gains. To guarantee a successful close, you need a dedicated team with your best interest in mind. The realtors at Green Residential in the greater Houston area fit that bill.
Our staff has decades of experience in the Houston market. We know it better than anyone and can help you price and market your property appropriately. We’ll also help you find those tax breaks to minimize what you owe while charging you a lower commission rate with a flat rate fee. To see if Green Residential is a good fit for you, contact us today!