Profits on the sale of investment property are regarded as taxable income. However, in many cases the sale may qualify for preferential capital gains tax rates. In addition, if you qualify, you can reduce your tax liability by taking advantage of an exclusion, by deducting losses from other transactions, and by writing off some of your investment expenses.
Capital Gains Tax
The capital gains tax applies to profits you derive from the sale of your investment property. Capital gains tax rates are lower than ordinary tax rates – 15 percent of your profit for most taxpayers as of 2012. Your profit is measured by the sales price minus your “adjusted basis” – the price you originally paid for the property plus the cost of improvements, eligible legal fees and selling fees. You must have owned your property for more than one year before you sold it; otherwise, you pay ordinary income tax rates.
Capital Loss Deduction
If you enjoyed a capital gain on one sale of investment property but incurred a capital loss on another sale of investment property – in other words, if you sold a property at a loss – you can subtract your capital loss in one transaction from your capital gain in another transaction. This is because capital gains tax is levied on your net capital gain for all transactions throughout the tax year, not your gain on each transaction. To qualify for a deduction, your capital loss must be incurred from the sale of property held for investment purposes rather than personal use.
The Homestead Exclusion
You might consider your home an investment property if you bought it primarily in hopes that it would appreciate in value. If you have owned and lived in your home as your main home for at least two of the past five years, however, the IRS classifies it as personal use property and offers a generous capital gains tax exclusion -- $250,000 as of publication, and $500,000 if you are married and filing your tax return jointly. You only have to pay capital gains tax that portion of your profit, if any, that exceeds the exclusion.
Suppose you sell real estate for $325,000. You purchased it 14 years ago for $200,000, added $35,000 in improvements and incurred $5,000 in costs associated with the sale. Your adjusted basis in the home is $240,000 ($200,000 + $35,000 + $5,000), and your capital gain is $85,000 ($325,000 - $240,000). If this capital gain is your only capital gain or loss for the year, you will owe $12,750 in capital gains tax (15 percent of $85,000). A similar calculation would apply if you sold another type of investment property, such as corporate stock.
Section 1031 of the Internal Revenue Code allows you to avoid paying capital gains tax if, instead of selling investment property, you trade one property for a similar property in a qualifying "like kind" exchange, as that term is defined by the IRC. Section 1031 also applies if you use the proceeds of a sale of investment property to purchase a similar property in a qualifying like-kind exchange. The purchase must take place within 180 days of the sale of the previous property, and within the same tax year as the sale. Although the rules for what is and is not "like kind" can get complex, two parcels of real estate almost always qualify as "like kind."
- Internal Revenue Servces: Investment Expenses
- Internal Revenue Service: Sales and Trades of Investment Property
- Charles Schwab: Investment Expenses: What's Tax Deductible?
- Internal Revenue Service: Ten Important Facts About Capital Gains and Losses
- Christian Science Monitor: The days of the 15 percent tax rate are numbered
- Internal Revenue Service: Maximum Exclusion
David Carnes has been a full-time writer since 1998 and has published two full-length novels. He spends much of his time in various Asian countries and is fluent in Mandarin Chinese. He earned a Juris Doctorate from the University of Kentucky College of Law.