Understanding Capital Gains: Timing is everything

Understanding Capital Gains: Timing is everything

Selling a home is often a moment to celebrate, especially if it has appreciated in value.

However, it’s essential to be prepared for the potential tax implications, particularly the capital

gains tax. There can be some serious downside to cashing in home equity when you sell. Real

estate can be very complex, that’s why serious thought & planning is required. If your home’s

value has significantly increased since you bought it, you might owe a portion of that profit to the

IRS. But don’t worry—there are ways to minimize or even avoid this tax. Let’s break it down.

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What Is Capital Gains Tax on Real Estate?

Research shows that one third of all capital gains come from property sales, the rest from

stocks. Capital gains tax is a tax on the profit you make from selling certain assets, including

real estate. Here’s how it works:

- Profit (Capital Gain): This is calculated by subtracting the purchase price (plus

expenses like closing costs and improvements) from the selling price.

- Tax Rates: If you owned the property for over a year, the long-term capital gains tax

rates—0%, 15%, or 20%—apply, depending on your income.

Real estate is a taxable asset, so any profit from selling a home must be reported to the IRS.

While the tax rates are usually lower than regular income taxes, they can still add up, especially

for high-value properties.

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How Does Capital Gains Tax Apply to Your Primary Residence?

The IRS offers significant benefits for homeowners selling their primary residence. If you meet

certain requirements, you can exclude:

- $250,000 of profit if you’re single.

- $500,000 of profit if you’re married and file jointly.

To qualify:

- You must have owned and lived in the home for at least two out of the five years before

selling.

- The two years don’t need to be consecutive.

Example:

If you bought your home for $350,000 and sold it for $600,000 after living in it for three years,

your $250,000 profit would fall under the exemption, meaning you owe no capital gains tax.

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Did you know:

- You can claim the primary residence exclusion every two years if you have lived there for

at least two years. A single day can make a difference when it comes to closing dates so

plan accordingly.

- If your spouse passed away and you sold with two years you could still take advantage

of $500,000 combined exemption.

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What About Rental or Investment Properties?

The rules for rental or investment properties are different. These properties don’t qualify for the

same exemptions as a primary residence. You may face:

- Depreciation Recapture Tax: A 25% tax on the portion of the profit tied to depreciation

you claimed as a landlord.

- Capital Gains Tax: Depending on your income, the profit balance is taxed at 0%, 15%, or 20%.

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Planning Tip:

If you’ve owned a rental property for less than a year, waiting to sell until after the 12-month

mark can lower your tax rate from short-term (up to 37%) to long-term capital gains rates.

Ways to Reduce or Avoid Capital Gains Tax

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Here are some strategies to keep more of your profits:

1. Meet the Primary Residence Requirements

If you lived in the home for two of the last five years, you could exclude up to $250,000

($500,000 for married couples) of your profit from taxes.

2. Convert a Rental Into Your Primary Residence

Moving into a rental property for at least two years can make it your primary residence, allowing

you to qualify for the exemption. However, you’ll still owe depreciation recapture tax on the

amount depreciated while it was a rental.

3. Use a 1031 Exchange

If you’re selling an investment property, you can defer capital gains taxes by reinvesting the

proceeds into another similar property. You are essentially rolling any tax liability forward

avoiding capital gains taxes. An exchange is a very underrated process with stringent timing

and unparalleled benefits. If you own income producing real estate, a 1031 exchange should be

an arrow you plan to shoot often.

4. Invest in Opportunity Zones

By investing in designated low-income areas, you can enjoy tax benefits, including reduced or

eliminated capital gains taxes after certain periods.

5. Deduct Expenses

Keep records of home improvements, repairs, and other eligible expenses. These can reduce

your taxable profit:

- Renovations like kitchen upgrades or adding a bedroom.

- Repairs needed to maintain or improve the property.

- Costs associated with selling, such as legal fees and advertising.

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Key Takeaway: Get Help!

Because the state and federal tax codes are detailed and confusing, the best advice I can give

you is to get help. Consult experienced and competent tax professionals before you decide to

sell or buy. I get calls after a rental property has sold all of the time. It’s typically too late and

saving a few bucks on the front side can cost you considerable change in the grand scheme of

things. Understanding capital gains tax and planning your sale wisely can save you thousands

upon thousands of dollars. Whether it’s meeting residency requirements, using a 1031

exchange, or keeping track of deductions, there are plenty of ways to reduce or avoid this tax.

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A tax advisor will ensure you’re making the most of the available strategies. That way, you can

enjoy the rewards of your home sale without unexpected surprises come tax season. Better yet

a Real Estate Planner can help you and the tax advisor make the most of appropriate planning.

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By simplifying the process and planning ahead, you can keep more of your hard-earned profits

and take the next steps in your real estate journey with confidence. The strategies discussed

above are some of the most basic and simple forms of thinking about real estate planning. For

an in-depth approach to your personalized situation please contact us for a strategy session.

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