Capital gains tax on real estate
If you are looking to sell your residence, then you should inform yourself of the tax laws thoroughly, because you could make a huge profit and not owe anything to the Internal Revenue Service.
Selling your house as a sole owner can bring you a profit of up to $250,000, and twice as much if you are married, without having to pay any capital gains tax on real estate.
Capital gains tax
In short, a tax that you pay when making a profit from selling a house is an example of a capital gains tax (CGT). CGT is imposed on profits that individuals or corporations incur by selling assets, such as property or stock shares. Capital gain is a positive difference between the sale price and the purchase price. The difference is then taxed, but only after the sale has been realized.
Taxpayer relief act of 1997
Before May 7, 1997, homeowners who were selling their property were free from paying sale profit taxes only in certain cases, for example, to use the money from the profit to buy a more expensive house within 2 years from the sale. It also applied to the sellers older than 55, who could request a once-in-a-lifetime tax exemption for the maximum profit of $125,000.
Since then, the Taxpayer Relief Act of 1997 has become law, which relieved millions from the residential sale profit tax burden. The rollover or once-in-a-lifetime benefits have been replaced by the current home sale exclusion rules.
Don’t forget to include all the costs when calculating your profit
If you make a substantial profit after you have sold an item, it is likely that the profit will be taxed on the capital gains grounds. However, keep in mind that all the investments made in regard to the sold item have to be included in the total profit incurred.
If you, for example, renovate the house or expand the backyard before the sale, make sure you add those costs to your investment, too. If the total expense exceeds the sale price, there is no need to worry about the capital gains tax.
Business profits are not capital gains
Capital gains tax is calculated only when the sale of personal residence or investments is in question, with the stress on personal.
If your job, be it full-time or part-time, is to trade properties, then another set of taxation rules will be applied to the profits made this way. Profits acquired as part of a business are considered business income and they are reported under a different category on your tax return. The money spent to run a business is considered a business expense, while the money gained is business revenue. When you subtract the expense from the revenue, you get a business profit that is according to the tax laws completely different from the profit you make by selling your personal property.
Taxpayers tend to confuse personal and business profits and they often report them incorrectly. In order to make it a bit clearer, try to imagine someone who appreciates restoring old cars as a hobby. They may invest some money to fix the mechanics, but then a year later they sell the car in order to buy another one and do a new project. Profit made in this manner is considered a capital gain. On the other hand, if someone is flipping cars more frequently than in the previous example, they are making business profits which fall under employment taxes.
Capital gains on home sale are most often exempt
Usually, the most valuable asset in people’s personal property is their home. Luckily, homeowners can realize extensive capital gains on real estate sale, which can be partly or completely excluded from the capital gains tax. In order to be eligible for the exclusion, they have to meet the following requirements:
- They were homeowners for at least 2 years in the period of 5 years before the home sale.
- That home was their principal residence in that same 5-year period.
- They haven’t excluded any other home sale gain 2 years prior to the home sale.
Meeting these requirements can ensure you a tax exemption on up to $250,000 if you are a single owner, or $500,000 if you share home ownership with your spouse.
Additional requirements to be considered
Using exemption options before the Taxpayer Relief Act of 1997 does not rule you out from any real estate capital gains tax exclusion that you intend to file for now. The act applies only to the sales realized after the law change.
Additional alleviation that the Taxpayer Relief Act brought is not having to spend your capital gain on another real estate purchase. You can save your money or spend them however and whenever you want.
It’s, however, necessary that it is your primary residence you’re selling in order to file for the tax exemption. It cannot be applied to any real estate that you don’t live in or that you own only for investment reasons. The capital gain made from selling non-primary property will be taxed according to the law.
Another condition is that you must have lived in your primary home at least 2 years before the sale. In other words, there has to be a minimum of 2 years between the sales in order for them to be excluded from the capital gains tax on a house sale.
Things to be considered if you’re married
It’s not enough for married couples to be eligible for tax exemption on profit up to $500,000; they need to fulfill certain requirements in order to be excluded from a capital gain tax.
In order to get the tax break, married couples need to pass certain tests. For example, you owned your home for at least two years, but then you got married and 6 months before the sale you added your spouse to the title as a joint owner. IRS would say that both of you passed the ownership test.
However, what’s more important is that both of you pass the use test. That means that both spouses must have lived in the primary residence for at least 2 years. If you got married 6 months before the sale but lived together at least 1.5 years before the wedding, then you are eligible for the exclusion.
Another important note is to be aware of your spouse’s homeowner history. If they had already claimed the exclusion within 2 years prior to the sale of your jointly held residence, then you cannot file for the exemption. So, if your spouse sold their home in the 2-period before the sale, you would have to wait until 2 years after that sale has passed before you can claim your tax-free deal as a couple.
Sometimes, if couples cannot get the full tax break because one partner does not meet the criteria, it is possible to lessen the tax on capital gain to a certain amount. They won’t be able to exclude the tax on the whole profit of up to $500,000; only a part of the profit can go untaxed given that one spouse is still eligible for the exemption.
Ending thoughts on capital gains tax on real estate
So, how much is capital gains tax? We recommend you inform yourself of the laws that may apply to you before making any big sale, but if your profit doesn’t exceed the limit, the IRS won’t have to be notified.
If you want to avoid paying a tax on a sale of a home that you lived in for at least 2 years, make sure you meet all the requirements, because otherwise, you can get in trouble. Also, don’t forget to include on your tax report any profit you make within a business, including reselling items of any kind, because they are not viewed as capital gains and cannot be excluded from taxes as such.