What is the capital gains tax in the US? Basically, it’s the income tax you pay on the profits from capital assets.
In other words, if you sell your home for a profit this counts as a capital gain. The amount of profit you earned will determine how much you’re charged for capital gains tax purposes.
The problem for many people is that the Tax Cuts and Jobs Act (TCJA), which is President Donald Trump’s signature tax reform bill, has altered everything. As of 2018, the rules have changed somewhat.
If you’re expecting a capital gain soon, this is what you need to know about it.
What is the Capital Gains Tax, and Do You Need to Pay It?
Capital gains tax is the tax levied on capital assets that sell for a profit. For most people, this will only ever apply to the capital gains on the sale of their home.
If you buy a home and sell that asset in a year or less, this is classified as a short-term capital gain for capital gains tax purposes.
Most people will hold their home for longer than a year and so they’ll be taxed at the long-term capital gains tax rates. It’s important to take this into account when selling a home because long-term capital gains are taxed at preferential rates, which could save you thousands of dollars in taxes.
What About the Tax Exemption for Your Home Being Your Primary Residence?
Home sale profits are different from other capital assets because they still have exemptions that can be applied, so your tax bill is lower. In some cases, you can even get a capital gains home sale exclusion and see your capital gains taxes wiped out entirely.
Understand that the IRS offers a $250,000 tax-free exemption on the sales of primary residences. So that means if you earn $250,000 or less from the sale of your primary home, you will never pay any capital gains tax.
This applies to everyone, no matter what they earn.
Let’s say that you have a primary residence you bought for $100,000. You sell this home for $600,000 with your wife many years later. You won’t have to pay any form of capital gains tax, if you adhere to the rules of the capital gains exemption. Remember, the exemption is for each person not per household.
Your home needs to be your primary residence, you must have owned the home for two years and lived in the home for two of the past five years. Furthermore, you can only take the exclusion once every two years.
If you don’t meet these requirements, you should talk to a tax accountant as they may be able to help you claim a partial exemption.
What is My Capital Gains Rate?
But what if you’re unlucky enough to qualify for paying capital gains tax ? Is there anything you can do about it?
That depends on several factors. Before, you used to be charged based on which tax bracket you fell into. Since the TCJA, it’s based on income.
You won’t pay anything on long-term capital gains if you’re single and earn less than $39,375. If you’re married but filing jointly you need to earn less than $78,750 to fall into the 0% tax bracket.
Heads of household also must earn $78,750 or less per year.
The 15% tax bracket is a little different. To fall into this tax bracket, single filers must earn more than $39,376 but less than $434,550. Taxpayers who are married and filing jointly must earn between $78,751 and $488,850.
For heads of household, this is between $52,751 and $461,700.
Anything above these limits and you fall into the 20% tax bracket, which is the highest capital gains tax bracket.
Do keep in mind that your state may charge its own capital gains tax. There’s also the 3.8% net investment income tax, but this is reserved for taxpayers on higher incomes.
Take note that if you owned the property for less than a year, you’ll pay short-term gain rates, which means your profits are taxed at standard income tax rates, so it’ll be taxed just like your salary.
That’s why it’s so profitable to hold assets so they qualify as long-term capital gains.
Will Your Home Improvements Reduce Your Capital Gains Tax Rates?
Did you know that you can also reduce the amount eligible for capital gains through making improvements to your home?
Any money you spent on home improvements can be added to the price you paid for your home.
Home improvement deductions that would qualify include replacing the floors, completing a basement, or renovating the roof of your home. The higher the adjusted cost, the lower the capital gain when you come to put your home back on the market for sale.
Let’s look at an example.
You paid $200,000 for a home back in 1990. You then turned around and sold that home 30 years later. Over that time, the value of your home has increased to $550,000. But over the period you held the property you spent approximately $100,000 on improvements.
For tax purposes, that $100,000 would be taken away from the sale price of the home. So instead of paying capital gains on $350,000 you would pay it on $250,000.
So technically you’d pay absolutely nothing in capital gains tax on the sale of that home.
There are no deductions for repairs and maintenance, however.
Keep in mind that you need to keep accurate records of any repairs and renovations you made, so you can prove the numbers you state on your capital gains tax reduction.
How Does Capital Gains Tax Work on Inherited Homes?
But what if you’ve been lucky enough to inherit a home and you want to sell it?
For that, the IRS offers a free step-up in basis. Let’s look at how this works in practice.
Your parents bought a home for $100,000. When they died, that home was worth $1 million. You might think that you now must pay capital gains tax on $750,000, which is the $900,000 in profit minus your $250,000 capital gains tax exemption.
But the IRS sets the ‘purchase price’ as the price the house was on the date of your parents’ death, so you wouldn’t pay any tax on this million-dollar home if you wanted to sell it soon after their deaths.
What About Real Estate Losses?
Are you selling your personal residence for less than you bought it for?
In that case, you can’t take a tax deduction for this capital loss. Capital losses from selling your residence doesn’t reduce how much of your income is subject to tax. The IRS classifies it as a personal loss.
But if you sell other real estate for a loss, you can take the tax loss on your return because they weren’t your residences.
Depending on the losses, you can offset how much of your income is subject to tax. But there may be limits on how much offsetting you can take advantage of during a one-year period.
How to Avoid Paying Capital Gains Tax
Real estate investors are those who most must worry about capital gains tax. So, let’s look at how they can avoid paying capital gains tax on real estate.
The easiest way to avoid paying the tax is by using the 1031 exchange to swap what’s known as ‘like-kind’ real estate. In practical terms, it allows you to sell a property and buy another one without recognizing the capital gain during that tax year.
So, it’s like swapping a single investment asset for another. Be aware that there are rules you need to adhere to. These are strict, so you should hire an accountant to help you with this.
Take note, this applies more to primary residences. You can avoid capital gains taxes on second homes but it’s much more complicated.
The 1031 exchange doesn’t apply to investing in another class of asset. Any capital gains profits will be eligible for tax.