Capital Gains Tax Basics
A capital gain occurs when the sales price you received for an asset is greater than your basis in that asset. The basis of an asset may be the price you paid for it. However, if youve made improvements to the asset, the cost of the improvements increases your basis. If youve depreciated the asset, that decreases your basis.
Ways To Avoid Capital Gains Tax On A Rental Property
When it comes to paying capital gains tax, many real estate investors believe they only have two choices: paying a short-term capital gains tax now or paying later at a lower, long-term capital gains tax rate.
Of course, some taxpayers may feel that its their civic duty to pay as much tax as possible. However, simply because other people believe the best use of their money is to give it to the government, it doesnt mean that you have to, too.
Here are four strategies you can use to avoid, reduce, and defer paying any capital gains tax at all.
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Avoiding Capital Gains Tax On A Rental Or Additional Property
If you own an additional property that you plan to sell, you will need to plan ahead to lower your tax liability. Three ways to avoid the tax liability include:
Establishing the rental as primary residence
You might find that an investment property you rent and plan to sell has spiked in value. It may be a good idea to move into the rental for at least two years to convert it into a primary residence to avoid capital gains. However, you wont be able to exclude the portion you depreciated while renting the property.
Youll lose primary residency status on your main home, but it can always be gained later by moving back in after the sale of the rental property. As long as you dont plan to sell the main home for at least two years, you can re-establish primary residency and qualify for the capital gains exclusion later.
You can also take advantage of a 1031 exchange. Known as a like-kind exchange, it only works if you sell the investment property and use the proceeds to buy another, similar property. Youre basically putting off capital gains tax indefinitely as long as you keep putting the sale of the proceeds into another investment property, you can avoid capital gains taxes.
The Cost Of Paying Taxes
Should you choose to sell your land and pay taxes, you could be subject to as many as four different taxes. Your profit on your land will be taxed at the federal capital gains rate, which is 15 percent or 20 percent for assets held over one year, depending on your income. You could also be subject to a 3.8 percent surcharge tax for Medicare as well as 25 percent depreciation recapture tax on any depreciated land improvements. Finally, you may also have to pay taxes to your state on the profit.
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State And Local Taxes
You may also see a state or local tax bill from the sale of your real estate. Most states have a real estate transfer tax system, where the seller is typically responsible for paying a tax on some portion of the property price. In some cases, the buyer may agree to cover the tax. The tax can often be added to the property’s cost basis for capital gains tax purposes.
You should also work with your local city or county government to make sure you don’t overpay or underpay property tax when you sell your land.
How Much Will I Pay In Capital Gains Tax
When searching online, you will likely come across a capital gains tax on property calculator. The formula that these calculators use is primarily the same.
Weve taken the time to provide you with the method used for a capital gains tax on property calculator so that you can estimate how much youll need to pay next year.
First, youll want to know your income. You will either be subject to tax at the basic rate or the higher additional rate-payer.
If your income defines you as a basic-rate payer, you could make enough on capital gains tax to push you into the additional-rate payer category. If this is the case, youll only pay the 28 percent tax on the amount that takes you over the threshold.
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How Taxes On A Rental Property Sale Work
There are a number of variables that affect tax paid on a rental property. Lets begin with some basic terminology first:
Cost basis is the original amount paid for a rental property, plus costs that must be capitalized such as real estate commissions paid and escrow and closing settlement costs.
Adjusted Cost Basis
Adjusted basis is the reduction in the original costs basis due to tax deductions such as depreciation expense and money received for granting an easement to your next-door neighbor.
Depreciation is a non-cash expense used to reduce your taxable net income. The IRS assumes residential rental property lasts for 27.5 years, which means the building loses 3.636% of its value each year.
Depreciation recapture occurs when a property is sold and the IRS taxes the real estate investor for the depreciation expense taken during the property holding period. Depreciation recapture is treated as normal income and taxed up to a maximum of 25%.
Rental property finances made easy.
Long-Term Capital Gains Taxes
Long-term capital gain is created when an asset such as investment real estate is sold after being held for more than one year. Tax on a long-term capital gain in 2021 is 0%, 15%, or 20% based on the investors taxable income and filing status, excluding any state or local taxes on capital gains.
Learn more about the capital gains tax rates for 2020 and 2021 from Kiplinger.
Short-Term Capital Gain
Techniques To Increase Your Property Basis
Examples of rental property improvements and transaction expenses that can increase the basis of a property and lower the amount of potential capital gain include:
- Upgrading doors and windows
- Replacing heating and cooling systems, electrical, and plumbing
- New appliances, flooring, and roofing
- Real estate sales commissions
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How To Calculate Capital Gains Tax On The Sale Of Property
In Canada, you only pay tax on 50% of any capital gains you realize. This means that half of the profit you earn from selling an asset is taxed, and the other half is yours to keep tax-free.
To calculate your capital gain or loss, simply subtract your adjusted base cost from your selling price. Divide that number in half and that amount will be taxed according to your income tax bracket, the province you live in, and your personal living situation.
Your adjusted base cost is your purchase price: what you paid for the property plus other costs incurred in the purchase such as commissions, legal fees and additions or improvements to the property.
Heres an example. Lets say that years ago you paid $250,000 for a house in Ontario. At that time, you paid $7,000 in taxes and closing fees plus another $28,000 on additions and renovations to the property. In this case, you would add all those expenses together to arrive at an adjusted base cost of $285,000. See the breakdown below:
|Original purchase price|
Your taxable profit on the sale is $82,500, which would be added to the rest of your income and taxed accordingly by the CRA based on your personal circumstances. While the same rules apply to all gains and losses from real estate sales, the rate at which gains are taxed is ultimately based on the income tax bracket you fall into. The other half of your capital gains also $82,500 can be pocketed tax-free.
How To Reduce Or Avoid Capital Gains Tax On Property Or Investments
Besides sales tax, excise tax, property tax, income tax, and payroll taxes, individuals who buy and sell personal and investment assets must also contend with the capital gains tax system. If you sell assets like vehicles, stocks, bonds, collectibles, jewelry, precious metals, or real estate at a gain, youll likely pay a capital gains tax on some of the proceeds.
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What Are Capital Gains Tax Rates
If you were to sell a property, the capital gains tax you would owe depends on three main factors: how long the property was in your name, your income, and your tax filing status.
According to Nate Tsang, the Founder and CEo of Wall Street Zen, tax on a long-term capital gain in 2021 is 0%, 15%, or 20% based on the investors taxable income and filing status, excluding any state or local taxes on capital gains. On the other hand, short-term gains are taxed on ordinary income rates and can go as high as 34%, depending on the income level. This is why it is advisable to hold an investment longer than a year so that you can take advantage of lower long-term capital gains tax rates.
How To Save Capital Gains Tax On Sale Of Land
08 min read
Land is a Capital Asset and and as an appreciated asset, a landowner can make huge capital gains on its sale. However, agricultural land in a rural area in India is not considered a Capital Asset. So, no capital gains are applicable on its sale. Before we find out how your capital gains shall be taxed, do make sure Income Tax considers your asset to be a capital asset.
Union Budget 2021 Outcome: The consideration so received or accrued as a result of the transfer of the residential unit shall be adopted to calculate the capital gain, if the stamp duty value is up to 120% of the consideration. The transfer of âresidential unitâ means an independent housing unit is the first time allotted to any person between 12th November 2020 and 30th June 2021 for a consideration not exceeding Rs. 2 crores.
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How Can I Reduce Capital Gains Tax On A Property
If your property isnt exempt from the capital gains tax, here are a few strategies to minimize or reduce it.
Live in the property for at least 2 years.
To get around the capital gains tax, you need to live in your primary residence at least two of the five years before you sell it.
Note that this does not mean you have to own the property for a minimum of 5 years, however. Once youve lived in the property for at least 2 years, youd reach capital gains tax exemption.
Plan to sell a property after youve experienced capital losses.
If youre going through a period in which youre producing less income than usual, it could be a good time to sell a property. Because your tax rate factors in your income, you can take advantage of a reduced rate.
Lets say that your spouse leaves her job to pursue studies. Prior to her resignation, your two-income household put you in a higher tax bracket that could mean a capital gains rate of 15%. With your drop in income, youre now in a lower tax bracket which means fewer taxes on any home sale during this period.
Track your home improvements or selling expenses.
Dont miss out on claiming all value you added to your house while living there. Keep track of how much you spend on improvements and upgrades to your property, and reflect that amount in your ultimate cost basis. Youll need records and receipts when submitting your taxes.
Turn your primary residence into a rental.
How Much Will I Have To Pay
Most taxpayers miscalculate their capital gains by simply subtracting the purchase price from the selling price. But under the tax code, purchase price and selling price are much more.
Your purchase price or cost basis is what you paid for the house or property plus all the taxes and fees you paid when you bought it, typically from 2% to 5% of the cost. You can also include money spent on projects that added value to the property, like that extra bathroom or garage improvements.
On the other end of your investment, your selling price is what you sell your property for minus any commission or closing fees you pay to sell it.
Lets say that years ago you paid $200,000 for a house. At that time, you paid $8,000 in taxes and closing fees. Since then, youve made $30,000 in improvements. In this case, your cost basis is $238,000.
|Original purchase price|
Your taxable profit on your recent sale is $212,000. And because you bought the home more than two years ago, you can walk away with your $212,000 tax-free.
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What Are Capital Gains Taxes On Real Estate
A capital gains tax is a tax on the gains you realized from the sale of an asset. The net profit on a home sale is considered a capital gain and can be taxed.
You are taxed on any profit if you sell your home within two years of buying it. If you hold the property for one year or less , youre liable for short-term capital gains, which are taxed as ordinary income. Youll pay the same federal rate on these gains as on wages and other earnings ranging from 1037%, depending on your household income.
If you sell after more than one year of ownership, your profits will be taxed as long-term capital gains, which have lower tax rates ranging from 020%.
But heres the good news. If you have owned and used your home for at least two years, you only pay those taxes on any profit over a certain amount the $250,000 or $500,000 thresholds for individuals or married joint owners respectively, as mentioned above.
Leverage The Irs Primary Residence Exclusion
You can be exempt from paying CGT when you sell a primary residence that meets certain criteria. Individuals can exclude up to $250,000 of capital gains while a married couple can exclude up to $500,000.
Under the Section 121 exclusion, youll have to own and use the property as your primary residence for two out of the five years immediately preceding the date of the sale. In addition, youre only eligible if you havent taken a capital gains exclusion for any other property sold at least two years before this current sale.
Since this strategy can only apply to one property being used as a primary residence, it wont benefit investors who have multiple investment properties. Moreover, youll need to hold onto a property for five years before you can take advantage of this exclusion.
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Convert Rental Property To Primary Residence
The IRS grants better tax benefits to those who sell a primary residence than investors who sell rental properties. Its becoming commonplace for rental property owners to convert their investments into primary residences before carrying out the subject propertys sale. That way, theyll be able to offset some of the capital gains taxes levied in their direction.
To make the deduction, homeowners must meet specific criteria set forth by the IRS. Namely, they must have owned the home for at least five years. Additionally, the homeowner must have lived in the subject property for two of the five years leading up to the sale. Thats an important distinction to make, as the amount of time the investor lives in the home will help determine the amount allowed to be deducted.
Offset Gains With Losses
One of the simplest ways to reduce your exposure to the capital gains tax is to offset the profits made from selling a home with losses that have been realized from another investment. While the Internal Revenue Service taxes profits made from investments, investors can deduct losses from their taxable income. Otherwise known as tax-loss harvesting, this particular strategy reduces exposure to taxes levied on gains. By accounting for both gains and losses, investors can reduce the capital gains they are taxed on.
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Business Income Isn’t A Capital Gain
If you operate a business that buys and sells items, your gains from such sales will be consideredand taxed asbusiness income rather than capital gains.
For example, many people buy items at antique stores and garage sales and then resell them in online auctions. Do this in a businesslike manner and with the intention of making a profit, and the IRS will view it as a business.
- The money you pay out for items is a business expense.
- The money you receive is business revenue.
- The difference between them is business income, subject to employment taxes.
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