Rental Property Vs Vacation Home
Rental properties are real estate rented to others to generate income or profits. A vacation home is real estate used recreationally and not considered the principal residence. It is used for short-term stays, primarily for vacations.
Homeowners often convert their vacation homes to rental properties when not in use by them. The income generated from the rental can cover the mortgage and other maintenance expenses. However, there are a few things to keep in mind. If the vacation home is rented out for less than 15 days, the income is not reportable. If the vacation home is used by the homeowner for less than two weeks in a year and then rented out for the remainder, it is considered an investment property.
Homeowners can take advantage of the capital gains tax exclusion when selling their vacation home if they meet the IRS ownership and use rules.
How Does The Capital Gains Tax Work
Lets start by giving you a feel for how the tax works.
For example, lets say you bought your home for $150,000 and you sold it for $200,000. Your profit, $50,000 , is your capital gain and its subject to the tax.
You only pay the capital gains tax after you sell an asset. Lets say you bought your home 2 years ago and its increased in value by $10,000. You dont need to pay the tax until you sell the home.
In this example, your homes purchase price is your cost basis in the property. Lets expand on that by assuming you spent $50,000 on a kitchen renovation. Thats a capital improvement, so your cost basis is now $200,000. Thats $150,000 + $50,000 . If you sell your home after the renovation for $200,000, your profit is $0, so theres no capital gains tax.
Cgt On Gifted And Inherited Homes
Your parents or relatives may want to leave you their home in their will. When they pass away, you’ll inherit the property at its market value at the time of death.
There is no CGT payable on death, but the value of the home will be included in the person’s estate. An estate is defined as being the total of someone’s assets and property, minus any debts and funeral expenses.
Depending on the value of the person’s estate, inheritance tax may be payable on the property.
If you then sell the property without having made it your own home, there could be CGT to pay.
The tax you pay will be based on the property’s value when you sell it, compared with its value on the date of death. If the value has increased, you’ll have made a taxable gain. As with any other property gains, you’re able to deduct any associated selling costs.
If youre given the home while the owner is still alive and living in it, this is called a ‘gift with reservation’.
Essentially, this means the value of the property will still be included in inheritance tax calculations when the gift giver passes away.
However, it may change things in terms of CGT. If you sell the property, the CGT you owe will be based on the increase in value between the date you were given the property not the date of their death and the date you sell it.
This is the case even though there may also be inheritance tax to pay on the home at the time of death.
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Basis When Inheriting A Home
If you inherit a home, the cost basis is the fair market value of the property when the original owner died. For example, say you are bequeathed a house for which the original owner paid $50,000. The home was valued at $400,000 at the time of the original owners death. Six months later, you sell the home for $500,000. The taxable gain is $100,000 .
The FMV is determined on the date of the death of the grantor or on the alternate valuation date if the executor files an estate tax return and elects that method.
How To Avoid Capital Gains Tax On Your Property
There are a number of concessions and exemptions when it comes to paying capital gains tax, and numerous strategies designed to reduce your overall tax bill, too.
Here are some of the main strategies used to avoid paying CGT:
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Time Capital Losses With Capital Gains
In a given year, capital losses offset capital gains. For example, if you earned a $50 capital gain selling Stock A, but sold Stock B at a $40 loss, your net capital gain is the difference between the gain and loss a $10 gain.
For example, suppose you sold a stock at a loss. If you have other stock that has appreciated in value, consider selling an amount of that stock, reporting the gain, and using the loss to offset the gain, thus reducing or eliminating your tax on that gain. Keep in mind, however, that both transactions must occur during the same tax year.
For some of you, this strategy might sound familiar. Its also referred to as tax-loss harvesting. Its a popular feature with many robo-advisors, including Betterment.
Use your capital losses in the years that you have capital gains to reduce your capital gains tax. All of your capital gains must be reported, but youre only allowed to take $3,000 of net capital losses each tax year. You do get to carry capital losses greater than $3,000 forward to future tax years, but it can take a while to use those up if a transaction generated a particularly large loss.
Option : Convert It To A Primary Residence
Some homeowners convert their rental property to a primary residence to avoid the capital gains tax. All of the stipulations of the primary residence exemption would then apply, including the:
- 2-year residency rule
- Income restrictions
- Regulation against using the exemption within two years of last use
If you can meet these requirements, youd have a higher ceiling before being subject to the capital gains tax. Individuals can make up to $250,000 and married couples up to $500,000 before they begin to pay tax on their capital gains.
Converting a rental property to a primary residence is not as easy as it sounds, especially when the rental property was acquired through a 1031 exchange. Congress made several changes to the IRS section 121 that requires a longer qualifying period for former rental properties before they can be converted into principal residence. With these changes in place, there is still a chance that the IRS would collect capital gains tax even after the conversion.88
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Example Of Selling A Second Home
Someone is selling a second home in England for £220,000 after buying it 10 years ago for £120,000.
Their capital gain is the increase in the property value, which is £100,000.
However, they spent £5,000 on solicitor fees and estate agent fees when selling the property, which reduces their gain to £95,000.
They have no other gains or losses, so they can simply use their £12,300 CGT allowance reducing the taxable part of their gain to £82,700.
The rate of CGT they’ll pay depends on their other income. In this case, let’s say it’s £25,000.
This means they’d pay 18% basic-rate CGT on £25,270 of their gain coming in at £4,548.60.
They’d have to pay the higher rate of 28% on the remaining £57,430, which is £16,080.40.
Altogether, the CGT bill would be £20,629.
Find out more: selling a buy-to-let property
Buy & Hold For The Long
As Rule #1 investors, we strive to invest in wonderful companies that will continue to grow for five, ten, or even fifteen years. The goal of this strategy is to see our money grow and compound and grow some more until we have created incredible wealth that will support us and help us survive.
That means watching investments double and triple in value over a matter of years. Not only will following this strategy make you money, but it will save you money on taxes too.
If you call yourself a Ruler, you will want to buy and hold your investments anyway, so avoiding short-term capital gains is relatively easy.
Remember this. Dont be influenced by peer pressure to sell early or to take part in day-trading. These tactics are like the shiny poison apple they look enticing but will only hurt you in the end.
Another way to avoid short-term capital gains is to set your investments and forget about them. Set price triggers to notify you if they drop in price so you can buy more and set news alerts to be notified of any major company news. Otherwise, leave your investments alone so you wont be tempted to sell them before you should.
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Suspension Of The Five
If you or your spouse are on qualified official extended duty in the Uniformed Services, the Foreign Service or the intelligence community, you may elect to suspend the five-year test period for up to 10 years. An individual is on qualified official extended duty if for more than 90 days or for an indefinite period, the individual is:
- At a duty station that’s at least 50 miles from his or her main home, or
- Residing under government orders in government housing.
Refer to Publication 523 for more information about this special rule to suspend the 5-year test.
Section 121 Doesnt Apply To Me What Now
Even if you dont meet the requirements for Section 121 exclusion, there are other ways to trim your capital gains tax burden or avoid it entirely. But these strategies involve the sale of an investment or rental property, rather than a primary residence.
The most common ways to reduce capital gains tax exposure include 1031 exchanges, converting a rental property to a primary residence, tax-loss harvesting, and monetized asset sales.
If you cant use any of these methods to avoid a hefty tax hit, selling with a low commission realtor could help you offset your costs.
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Do I Qualify For Partial Exclusion Of Gain
Even if you dont meet the eligibility test for full exclusion of gain, you may qualify for partial exclusion.
People can qualify for partial exclusion if they sold their home because of a work-related move, a health-related move, or a major unforeseeable event such as the death of a spouse or their home being destroyed or condemned.
Check the IRS site for more details about which situations and circumstances qualify.
How Do Capital Gains Taxes Work On Real Estate
The IRS typically allows you to exclude up to:
-
$250,000 of capital gains on real estate if youre single.
-
$500,000 of capital gains on real estate if youre married and filing jointly.
For example, if you bought a home 10 years ago for $200,000 and sold it today for $800,000, youd make $600,000. If youre married and filing jointly, $500,000 of that gain might not be subject to the capital gains tax .
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How To Calculate Your Capital Gains
To arrive at the Short Term Capital Gains From the total Sale Price of the asset deduct cost of acquisition, expenses directly to sale, cost of improvements also deduct exemptions allowed under section 54 > the resulting amount is the Short Term Capital Gain. In case of Long Term Capital Assets, the only difference is, one is allowed to deduct Indexed Cost of Acquisition/Indexed Cost of Improvements from the sale price. Indexation is done by applying CII . This increases your cost base since the purchase price is adjusted for the impact of inflation.
How To Avoid The Capital Gains Tax On Real Estate Home Sales
Sherman-May 13, 2021
If youre thinking about selling real estate, one thing that you need to keep in mind is the amount of taxes youre going to pay on that sale.
Theres a lot of money involved in selling property, and anytime money swaps hands, you can bet that Uncle Sam is coming for his piece of the pie.
Uncle Sams piece of the pie is called the capital gains tax. And the capital gains tax on real estate works a lot differently than other forms of taxes.
So today, were going to take a close look at the capital gains tax on real estate, and also give you 2 strategies to avoid this tax altogether.
In this post, were going to break down the capital gains tax on real estate transactions to help you understand and minimize any taxes you might owe.
Of course, this is not legal advice and we are writing this post for informational purposes only.
Alright, lets talk about the capital gains tax.
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If You Don’t Meet The Use Test
Now let’s say that you still have some capital gains that don’t seem to fall under the exclusion. Even if you haven’t lived in your home a total of two years out of the last five, you’re still eligible for a partial exclusion of capital gains if you sold because of a change in your employment, or because your doctor recommended the move for your health, of if you’re selling it during a divorce or due to other unforeseen circumstances such as a death in the family or multiple births. In such a case, you’d get a portion of the exclusion, based on the portion of the two-year period you lived there. To calculate it, take the number of months you lived there before the sale and divide it by 24.
For example, if an unmarried taxpayer lives in her home for 12 months, and then sells it for a $100,000 profit due to an unforeseen circumstance, the entire amount could be excluded. Because she lived in the house for half of the two-year period, she could claim half of the exclusion, or $125,000. That covers her entire $100,000 gain.
First How Much Is Your Gain
Many people mistakenly believe that their gain is simply the profit on the sale: “We bought it for $100,000 and sold it for $650,000, so that’s a $550,000 gain, and we’re $50,000 over the exclusion, right?”. It’s not so simple — a good thing, since the fine print can work to your benefit in such instances.
Your gain is actually your home’s selling price, minus deductible closing costs, selling costs, and your tax basis in the property.
Deductible closing costs include points or prepaid interest on your mortgage and your share of the prorated property taxes.
Examples of selling costs include real estate broker’s commissions, title insurance, legal fees, advertising costs, administrative costs, escrow fees, and inspection fees.
So, for example, if you and your spouse bought a house for $100,000 and sold for $650,000, but you’d added $20,000 in home improvements, spent $5,000 fixing the place up for the sale, and paid the real estate brokers at least $25,000, the exclusion plus those costs would mean you’d owe no capital gains tax at all.
For more information, see IRS Publication 551, Basis of Assets, and look for the section on real property.
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How Does Letting Relief Work With Cgt
If you have let out either all or part of a property, a proportion of any gain when you sell it could be taxable. But if you used to live in the property , you might be able to claim letting relief, which will reduce your capital gains tax bill.
Letting relief doesn’t apply to buy-to-let investors who let out their properties and never live in them.
For 2020-21 tax returns, lettings relief was only available for people who were in shared occupancy with their tenant/tenants.
The amount of letting relief you can claim will be the lowest of either:
- the gain you receive from the letting proportion of the home, or
- the amount of private residence relief you can claim, or
- £40,000.
Note that you can’t claim private residence relief and letting relief for the same period. So, if you are letting the property out when you sell it, the past nine months of ownership will qualify for private residence relief rather than letting relief.
The exact amount of private residence relief and letting relief you can get depends on the amount you sell the home for.
Rate And Payment Of Capital Gains Tax
The standard rate of Capital Gains Tax is 33% of thechargeable gain you make.
A rate of 40% can apply to the disposal of certain foreign life assurancepolicies and units in offshore funds.
For certain windfall gains the windfallgains rate of tax is 80%.
Deductions
You can deduct allowable expenses from the chargeable gain, including:
- Money you spent that adds value to the asset
- Costs to acquire and dispose of the asset
You may also be able to deduct an allowableloss you made in the same tax year.
The first 1,270 of taxable gains in a tax year are exempt from CGT. Ifyou are married or in a civil partnership, this exemption is available to eachspouse or civil partner but is not transferable.
Capital Gains Tax can be more complex than the examples above. For thisreason, you should get advice from Revenue.
The tax year is divided into two periods:
- An ‘initial period’ from 1 January to 30 November
- A ‘later period’ from 1 December to 31 December
For disposals in the initial period CGT payments are due by 15 December inthe same tax year. CGT for disposals in the later period are due by 31 Januaryin the following tax year.
For example, if you dispose of an asset in the period January to November2022 you must pay the Capital Gains Tax due to Revenue before 15 December 2022.If you dispose of an asset in December 2022, the Capital Gains Tax will be dueon 31 January 2023.
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