Capital Gains Tax on Real Estate: The Misconeptions

Knowing the rules before you begin is important in any task you to decide to undertake. It doesn’t matter how you gained value on your property, whether the market naturally made your home value rise, you completed a few big time renovations, or whatever, it’s still exciting. The only thing that can diminish your excitement is taxes on your gain. This is called the capital gains tax.

The law passed in 1997 called the Taxpayer Relief Act helps homeowners keep much of the gains on their home sale. Before 1997 homeowners could only “pull out the once-in-a-lifetime card” that exempted them from taxes up to $125,000 on a home sale, or their home earnings were expected to roll into the purchase of their next home. Today’s rules aren’t so strict, so let’s take a look at those loopholes.

Tax Treatment: house flippers vs. homeowners

A common misconception is that all house sales are treated equally. This is not the case for house flippers. In order to receive the best tax treatment on your gains, you need to use that house as your permanent residency for at least two years. For professional house flippers, houses are considered inventory as opposed to capital assets, and the profit is taxes as income. The long-term capital gains tax is 15% for most people, and 20% for those in the top tier tax brackets. If your gains are taxes as income (professional flippers) your taxes could span from 10% to 40% depending on the rest of your income. House flippers cannot simple avoid the tax by rolling their profits into the next house.

Exemption Limits: Filing married vs. single

The Taxpayer Relief Act voided the once-in-a-lifetime tax exemption of $125,000, exemption limits haven’t completely fallen by the wayside. You are now allowed to keep up to half a million dollars of each home sale profit tax free if you are married, or up to a quarter million dollars if you are single. It is a bit trickier if you are newly married. If one spouse owns the home for the past two years, and the newest spouse isn’t on the title until the past several months, that is okay. Both parties need to have lived in the house for two years prior to the sale, even if only one of them was on the title before they were married. If one of the spouses made some money by selling a previous home within the last two years and was exempt, the couple must now wait until they are both out of the that two-year window before pocketing any gains from their shared home.  

Type of Home: Primary Residence vs. Vacation home or rental property

If you aren’t a professional home flipper, and have a second home or a rental home you’d like to sell after living there for the required two years, it won’t be treated as a primary residence for tax purposes. Your second homes do not receive the same tax shelters they did before a 2008 shift in the tax code- even if the home becomes a primary residence for a short period of time. Now when tax time comes around, you owe a prorated amount based on the number of years the property was used as a second home, or was rented out after 2008. If you happened to use your Florida home as your primary residence for five years in 2010, but used it as your vacation home for the past fifteen years, only 10% of those gains would be taxed. The two years after 2008 when it was used as a vacation home equals 10% of the total 20 years of home ownership. The rest of your profit wouldn’t be taxed as long as it fell within the exemption limits.

Profit: Large sale price cs. Small sale price

The last misconception is that the more a home sells for the larger the tax bill will be. For tax reasons, what you owe doesn’t depend on the sale price – it’s based on how much profit you make from the sale. You could essentially sell a home for a million dollars and now owe a dime in taxes, as long as you didn’t make more than the allowed exemption amount on the sale.

Just so know you, capital gains tax on real estate isn’t necessarily an all-or-nothing proposition. If you are near the exemption limit, you can still qualify for a partial exemption, just be sure to ask your tax consultant before you make any moves. 

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