It’s not uncommon for homeowners to be shocked to learn that they owe thousands of dollars in Capital Gains Tax after selling their homes. Nearly all homeowners have appreciated the value of their home since purchasing it, but that doesn’t always mean they should expect a tax bill after selling it. If you’re looking to purchase a home or sell your current home, the capital gains tax is something you need to be aware of. Curious about capital gains tax on a home sale? Are you worried about paying an exorbitant tax bill? Or worse, are you concerned that you’ll be forced to pay capital gains tax on your home even if you aren’t selling it? If any of these sound familiar to you, you’re in the right place. This post will answer frequently asked questions regarding capital gains tax on a home sale, including what it is and how to navigate it.
What is capital gains tax on a home sale?
If it’s your first time selling a home, the chances are that you’ve probably never even heard of something called capital gains tax before. Now, when you’re preparing to sell your home, you’re probably confused as to whether or not you’ll have to pay taxes on the gains that you earn when you sell your house. After all, you’ve been living in this house and paying the mortgage for many years. But the truth is that you’ll have to pay capital gains tax on the profit you make when you sell your home.
Capital gains tax on a home sale can simply be described as the tax on the profit you make if you sell an asset (in this case, your house), and that sale results in a gain.
Let’s say you bought a home for $175,000, but today the home is worth $250,000. In this case, you will owe the IRS about $75,000 for the capital gains on tax. There are many exceptions to the capital gains on tax. For example, if you sell your home because you are moving to a new place because of your job, you may not owe any capital gains tax. Also, if you sold your home for more than a million dollars, the IRS will only tax a certain percentage of the profit. Capital gains on tax are a complicated subject, so it’s crucial to consult with an expert if you have any questions. Capital gains tax is an essential consideration in deciding to sell, when to sell, and how to sell.
How does capital gains tax on a home sale work?
For starters, it’s best to understand how capital gains on a home sale works.
The following example illustrates how capital gains tax on a home sale works:
Step 1: Calculate the capital gain.
The capital gain is the difference between the net sales price and the original purchase price, minus the cost of any capital improvements.
Original purchase price – Net sales price + Cost of any improvements = Capital gain
$200,000 (original purchase price)
– $150,000 (net sales price) = $50,000 (capital gain)
Step 2: Calculate the income tax.
The income tax on the capital gain is calculated by using the following formula:
Tax rate x Capital gain = Income tax
0% (income tax rate) x $50,000 (capital gain) = $0 (income tax)
What is the capital gains tax rate?
There are several differences in home sales taxes in the states and countries. Pennsylvania, for example, has a sales tax on real estate of 1.425%. On the other hand, the state of Texas typically has no sales tax on property. The British Columbia (Canada) provincial sales tax is 5% for homes under $500,000. Ontario’s provincial share is 5% for all homes. Alberta has a 5% provincial sales tax on new and used properties under $350,000. British Columbia is currently the only province in Canada with a provincial sales tax on property. The House Capital Gains Tax Rate ranges from 0% to 25%, depending on the amount of profits made on the sale of the property. In the UK, for example, the Capital Gains Tax Rate is 20%.
Short-term vs. long-term capital gains tax
There is the short-term and long-term capital gains taxes when it comes to selling your home. To know which tax you will incur, you must know whether you sold your home within one year of purchasing.
Short-term gains are taxes on any profit you made on the sale of your home that was realized in the same year. If you sell your home for $500,000 and it was originally purchased for $200,000, then you have a $300,000 short-term capital gain, and you would owe 39.6% federal income tax, which is $131,200, plus state and, of course, local taxes, which can vary by locale. Long-term capital gains taxes are taxes on any profit you made on the sale of your home that was realized after five years. If you sell your home for $500,000 and it was initially purchased for $200,000, you have a $300,000 long-term capital gain, and you would owe 20% federal income tax, or $60,000, plus state and local taxes.
So, between short-term and long-term capital gains, which is better?
The answer is neither since your tax bracket and tax treatment of dividends will be different for each. However, long-term capital gains are more attractive for investors with value concerns because you don’t have to anticipate the passage of future capital gains tax cut legislation. Let’s take the case of a low-cost S&P 500 index fund, which serves as a proxy for any index fund that invests in common stocks. If you invest $1,000 in the fund at the beginning of the year, and the fund’s value increases 10% to $1,100 by the end of the year, your capital gain would be $100, and if you are in the 10% tax bracket, you will pay $10 in taxes on the $100 gain.
Tips on how to avoid capital gains tax on your property
Now that you understand the basics of capital gains tax when it comes to selling your property, it will help you seek ways to avoid the capital gains on the property. Some of the ways to achieve this include:
- Reducing your cost basis of the property
If you can reduce your property holdings to less than $250,000, you are out of the realm of capital gains. If you sell your property, it will be taxed as ordinary income. You may take advantage of this by selling a property that you are no longer using to one of your children and giving them the property at a lower capital gains rate.
- Transfer the property to your children
If you would like the property to remain in your family, it may be best to transfer it to your children- depending on their age- for a reduced capital gains tax rate.
- Sell the property to your spouse
If you are married, you may be able to sell the property to your spouse for a reduced capital gains tax rate. By so doing, you will be able to avoid paying taxes on the gain. If you have a low-income spouse, you may be able to report the sale as a gift (rather than a sale) to a spouse.
In this case, the property is treated as though you sold it entirely to your spouse. The capital gains are calculated based on the difference between the combined sales price and acquisition cost. Also, it would be best if you were careful.
- Leave the property to a charity
If you would like to forfeit the property to a charity, you will have to make sure that the property is not worth more than the charitable deduction limit.
There are several rules that you need to follow:
The donation of the property will only be tax deductible if you get an acknowledgment of the donation. The acknowledgment must include the amount of the cash donation and the property’s fair market value. If the property value is more than the charitable deduction limit, you need to pay income tax on the amount of the property value that is more than the limit.
- Get the timing of your capital gain right
For instance, if you know your income will be lower come the following year, you can sell some capital assets at the end of the current financial year. You’ll have to report the sale of such assets in your tax return for the year, which will result in a capital gain that you pay tax on. But come the following year, you will, in all probability, have lower income and lower tax liability, thus reducing your tax outgo relative to what it would have been had you not sold those assets.
How do I get around capital gains tax when I sell my house?
This is one common question you will find first-time home sellers asking. The best answer is to keep it simple. If you are a first-time home seller, do not try to find creative ways to minimize your capital gains. That may work out well for you in some cases, but you may also mess up sometimes. It would be best if you used the basic exemption limit to avoid paying any capital gains tax on the sale of your house. You will find that this is easier than trying to figure out your capital gains tax each time you sell your house.
There are some strategies where a seller can potentially avoid capital gains tax. Some can be done before you sell your home, and others take place after you’ve sold.
Here are ways to reduce the tax burden when selling your home potentially.
- Capital Gains Exclusion
If you have owned a home for one year or more, you can exclude from tax up to $500,000 on profits from the sale of your primary residence. If you have owned a home for less than a year, you may still be able to exclude a portion of your profit.
- 1031 Exchange
If you sell your home and buy another, you can defer paying capital gains tax by using a 1031 Exchange. For instance, if you bought a home for $100,000 but decide to sell it for $200,000, you plan to buy another home that costs $200,000. The difference in your gain (the $100,000) can be deferred to another property.
To qualify, you must find a property that costs at least as much as your old home. Then close on both homes within 45 days. The hardest part about a 1031 Exchange is finding a suitable property.
Is a residential house subject to capital gains tax?
Yes, a residential house is subject to capital gains tax, and there are two types of capital gains taxes:
Capital gains accrued on your primary residence and vacation homes;
Capital gains accrued on all other properties outside your primary residence, including commercial and industrial properties.
How is capital gains tax calculated?
The capital gains tax is calculated by first determining the cost-basis, then calculating the difference between the cost-basis and the item’s sale price, and then applying either the statutory rate or the preferential rate.
What is the cost basis?
The cost basis is calculated by reducing the sale price by the amount of any exemptions, depreciation, and capital cost allowance.
What is the statutory rate?
The statutory rate is the rate of the lowest marginal tax bracket. The statutory rate is found by taking the lowest marginal tax bracket and multiplying it by 10%. The marginal tax bracket is the bracket in which a special tax rate starts to be applied. The marginal tax bracket is the tax bracket that falls immediately below the bracket in which an individual taxpayer’s income sits.
The lowest marginal rate for a single person in the US is 15%.
By understanding everything about capital gains on a home sale, you are better prepared to make smart decisions. If you are in the market for a new home, now you have a better understanding of what you can afford to buy. If you are selling your home, you have a better idea of how you can calculate your potential capital gains taxes and what you will need to do to minimize capital gains tax.