In many cases, if you sell real estate for more than you paid for it, you will owe capital gains tax on the real estate to the Internal Revenue Service. The same is true for other types of investments, including securities like stocks and bonds. There are, however, legal ways of avoiding capital gains tax on the sale of a home through IRS-approved exclusions. You can also sometimes avoid capital gains tax on real estate for business use by buying other real estate with the proceeds.
How Capital Gains Tax Works
Ordinarily when you sell a valuable asset that you've held for a year or more for more than you paid for it, you are required to pay long-term capital gains tax on the net proceeds. For most taxpayers, this is charged at a rate of 15 percent, while some taxpayers pay zero percent or 20 percent depending on their overall income and tax tables published by the IRS. If you've held on to the asset for less than one year, you must pay tax on the gain at your ordinary income tax rate.
Certain costs related to acquiring and selling the asset are excluded from capital gains, like commissions paid to stock and real estate brokers, as well as the cost of legal fees, notaries, title research companies and the like. Many improvements and renovations to a home are also effectively added to the purchase price, or cost basis, when figuring capital gains, but repairs are not.
Thoroughly document any potential expenses that can boost your cost basis and how they're related to the real estate and transactions involved. Then, keep these records in case your tax return is ever audited by the IRS.
Offset With Capital Loss
Long-term capital gains tax rates are generally lower than the ordinary income rate you pay on income from work and other earnings like bank interest, but they can still add up if you had a highly profitable investment. If you've lost money on an investment at the time you sell it, or you had stock or something else that became worthless, you can write off the money you've lost as a capital loss.
A capital loss can offset capital gains or up to $3,000 in ordinary income on your taxes, and you can roll capital losses into future tax years to offset future capital gains and income, though you can't roll them backward to offset previous earnings. This means it can be worthwhile to balance the sale of a profitable asset with one that has lost money. An online capital gains tax calculator on the sale of property or a professional tax adviser can help you estimate what you owe.
Selling Your Home for Gain
Special rules apply if you sell your main residence for a capital gain. You can generally exclude up to $250,000 in capital gains from taxation or up to $500,000 for married couples filing jointly provided you meet the IRS requirements. Specifically, you need to have owned the house and used it as your main home for two years within the five years prior to the home's sale.
The period where it was your main home and the period where you owned it don't have to be the same period. If you're married and filing jointly, only one spouse has to meet the two-year ownership requirement, but both spouses must meet the primary residency requirement to get the tax exclusion.
Some special exemptions to the five-year requirement can apply if you were stationed away from home while in the military, the intelligence services or the U.S. Foreign Service, or if you were physically or mentally unable to care for yourself. You can also apply special rules if your spouse died, you were divorced or separated while owning the home or if your home prior to the one being sold was destroyed or condemned.
You're also allowed to count the separate sales of vacant land adjacent to your home and your home itself as one transaction for tax purposes in certain situations.
The income exclusion is only permitted for use on one home in any two-year period, even if you'd otherwise meet the requirements on more than one home. If you're not sure whether the exclusions apply to you, study the IRS materials on the subject and consider working with an accountant or lawyer.
Understanding Like-Kind Exchanges
If you own real estate for a business or investment and you sell it, then quickly buy other real estate, you can defer paying capital gains tax on the initial sale until you sell the new property. This procedure is called a like-kind exchange or, after the section of the tax law that enables it, a 1031 exchange.
The rules around this procedure are somewhat precise, so it is important to make sure you do it in accordance with the law to avoid owing unnecessary tax. Generally, you must have the proceeds of the sale of the initial property transferred to a qualified intermediary rather than receiving cash for the sale. Then, you must designate the desired replacement property in writing to the intermediary within 45 days of the sale and close on it within 180 days.
The 1031 exchange generally applies only to business and investment real estate, not your primary home. As of 2018, the 1031 exchange is only used for real estate, not for other investments like securities or artwork.
Like-Kind Exchanges – Boot
If you receive money from the sale, that's known as boot, and it's taxable as a capital gain. For example, funds used to pay off a mortgage on the initial property if you don't have a similarly sized mortgage on the new property would be considered boot.
If you're not sure whether a transaction can be counted as a 1031 exchange, consider working with an expert, such as a lawyer or accountant, to understand your tax liabilities and how best to structure the transactions applied.
Inheriting Real Estate
Special rules also apply for capital gains taxes if you inherit real estate or other capital assets and then sell it. Typically when someone dies, the cost basis of real estate, stocks and other capital assets he or she owns reset on the day of death. In certain circumstances, if chosen by the administrator of the estate, the cost basis resets six months after the day of death.
For an appreciating asset like a house or stock that's performing well, that means it may be advantageous to allow your heirs to inherit the asset rather than selling the asset, paying capital gains tax and passing the net proceeds on to your heirs.
Donating Capital Assets
If you own real estate or other assets that you'd have to pay capital gains on if you sold them, and you want to make a charitable donation, it can sometimes be more advantageous to donate the assets to charity. You can often claim the fair market value of the asset, up to 30 percent of your adjusted gross income, as a tax deduction and will avoid paying capital gains tax on the sale of the asset.
For assets, including real estate, worth $5,000 or more, you must have the assets professionally appraised to claim the deduction unless they're cash or securities. Hold on to all records related to the donation and appraisal in case they're requested by the IRS. Remember that you must itemize your tax deductions to claim charitable donations.
- Special circumstances qualify you for the capital tax gains exemption even when you do not pass the ownership and use test. Stays in nursing homes and an unexpected move because of a job transfer are two such events. A tax accountant can advise you if you are not sure whether your situation makes you eligible for the exemption.
- Marketwatch: Your Simple Guide to the New Capital Gains Tax Rates
- NOLO: When Home Sellers Can Reduce Capital Gains Tax Using Expenses of Sale
- IRS: Capital Gains, Losses, and Sale of Home
- IRS: Topic Number 409 - Capital Gains and Losses
- IRS: Topic Number 701 - Sale of Your Home
- IRS: Like-Kind Exchanges - Real Estate Tax Tips
- CWS Capital Partners: What Is a 1031 Exchange? The Basics for Real Estate Investors
- Capital Improvements
- IRS: Gifts and Inheritances
- IRS: Charitable Organizations - Substantiating Noncash Contributions