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Regardless of why you own a house, the Internal Revenue Service will levy capital gains taxes on some or all of your profits. While the tax treatment differs depending on why you own the property, the capital gain calculation is the same. You subtract your cost from your sales basis to find your profit.
Capital Gains Math
Calculating your capital gains starts with finding your adjusted cost basis, which is what the IRS uses as your cost for the property for capital gains purposes. The adjusted cost basis has three components -- the original purchase price, any closing costs that you paid for the property but not the loan, and the cost of any improvements that you made to the property. You subtract your adjusted cost basis from your sale basis. The sale basis is what you received for the property after any closing costs or commissions.
Capital Gains Tax Rates
For the 2013 tax year, the IRS has multiple capital gains tax rates. Short-term gains, which are profits you earn on properties you hold less than one year, are taxed at your marginal income tax rate. For long-term gains, if your income is under $450,000 if you are married or $400,000 if you are single, the rate is 15 percent. If your income is over the threshold, the rate is 20 percent. If your income is over $250,000 if you are married or $200,000 if you are single, you will have to pay a 3.8 percent Medicare surcharge on both short- and long-term capital gains. Finally, if you are selling a depreciated rental property, you could be subject to 25 percent recapture tax, which can also qualify for the Medicare surcharge.
If you have lived in your house for at least two of the last five years, the IRS treats it as a personal residence and allows you to exclude a portion of the gain from tax. Your first $500,000 if you are married, or $250,000 if you are single, is tax-free. The IRS excludes it both from capital gains taxes and from the Medicare surcharge. When you sell a second house that you own for personal use, like a vacation home, you don't get the same treatment. You have to pay capital gains taxes on it and may also have to pay the Medicare surcharge. If you're willing to turn that house into your primary residence, though, and live in it for at least two years, you can claim the capital gain exclusion but it will be reduced depending on when you bought the home and how long you owned it. If you also used it as a rental property, your ability to claim the exclusion will be limited.
Investment properties are subject to the same capital gains taxes as a personal residence, but without any exclusion, so every penny of profit is taxable. If you sell the property for more than the depreciated basis, which is the adjusted cost basis minus all of the depreciation you claimed, you will also have to pay depreciation recapture tax. You pay 25 percent depreciation recapture tax on the difference between your depreciated basis and your adjusted cost basis up to the total amount of depreciation you claimed. Recapture tax is also subject to the 3.8 percent Medicare surtax if your income is high enough.
If you intend to spend everything you receive from the sale of your rental property on more rental property, you may be able to defer paying the capital gains tax, Medicare surtax and recapture tax. To do this, you need to structure the transaction as a Section 1031 tax-deferred exchange. 1031, or Starker, exchanges require you to do special paperwork, have a third party hold your money between the sale of your relinquished property and the purchase of your replacement property, and meet stringent time lines. In exchange for following the rules, you get to carry your depreciated basis forward to your new property and defer all your taxes.
- IRS: Publication 551 - Basis of Assets
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