In 2020, Americans paid an estimated $158 billion in federal capital gains taxes. That's a hefty sum, and it can hit real estate investors particularly hard. These taxes hit investors when they realize a profit from their investments, somewhat like an income tax on investment proceeds. But long-term capital gains work a little differently than regular income taxes do.
So how do capital gains taxes work? And how does it impact real estate investments? This guide will help you sort it out.
What Is Capital Gains Tax?
Capital gains tax is the tax you pay when you profit from an investment.
For example, if you invest $1,000 in stocks and sell those stocks for $1,500, you would have a profit (capital gain) of $500. And you would pay a capital gains tax on that $500.
There are two types of capital gains:
- Short-term capital gains: If you buy an asset and sell it within the first full year of ownership, you have a short-term capital gain. These are taxed at the same rate as your normal income.
- Long-term capital gains: If you buy an asset and hold it for longer than a year before selling it, you have a long-term capital gain. These are taxed at rates lower than your normal income. We’ll get into more specifics below.
Capital gains are taxed at the federal level. Many state and local taxing authorities charge their own capital gains taxes, as well.
How Does Capital Gains Tax Work in Real Estate?
Capital gains tax works the same for real estate as it does for other investments, but with two key differences.
Calculating Your Cost Basis
The “cost basis” is the amount you pay for your investment. For investments like stocks and bonds, the cost basis is usually just the purchase price (plus any fees you paid to make the purchase). But for real estate investments, you get to add the cost of certain acquisition fees plus improvement costs to your cost basis.
For example, say you paid $200,000 for an investment property. You also paid $10,000 in qualifying acquisition costs and invested $75,000 in rehabbing the property. Your cost basis would be $285,000 ($200,000 + $10,000 + $75,000).
Now, say you sell the property for $400,000. Your capital gains would be $115,000 ($400,000 - $285,000). So you don’t end up paying taxes on the $10,000 you paid in acquisition costs or the $75,000 you paid to improve the property because those expenses are included in your cost basis.
The Primary Residence Exemption
There is a capital gains exemption for primary residences. This means you won’t pay the full capital gains tax (if any) when you sell the home you live in. Currently, the exemption is $500,000 for married couples filing jointly and $250,000 for individual taxpayers. You can deduct this amount from your gains before calculating your taxes due.
You need to meet two different "two-year tests" to qualify for the exemption:
- You must have owned the home for at least two of the past five years.
- You must have lived in the home for at least two of the past five years.
These two-year periods can be the same, overlap, or be completely different timeframes as long as they occur within the five years before the sale.
How Much Are Capital Gains Taxes?
Short-term capital gains count as ordinary income, and you'll pay those taxes at your normal income tax rate.
Long-term capital gains are taxed differently. Like normal income tax brackets, long-term capital gains tax brackets can change every year. Also like normal income, taxes can be levied at both the federal and local levels.
For Federal Capital Gains Tax
In general, lower-income households pay no capital gains taxes. Moderate-income households pay up to 15%. High-income households, meanwhile, pay up to 20%.
Visit the IRS website for a complete breakdown of percentages based on your income.
For State Capital Gains Tax
Most states charge capital gains tax in addition to the taxes you pay to the federal government. For the states that do charge capital gains taxes, the rate varies from 2.9% in North Dakota to 13.3% in California.
Be prepared for your state taxes by checking your state's capital gains rates.
How To Minimize Your Capital Gains Tax Burden
Here are a few ways tokeep your capital gains taxes as low as possible:
- Keep good financial records. You can add certain acquisition fees and improvement costs to your cost basis. You just need to have documentation for these expenses.
- Hold your investments for the long term. By keeping your assets for longer than a year, you can pay the lower long-term capital gains tax rates.
- Consider doing a 1031 exchange. A 1031 exchange allows you to swap an investment property for a higher-value, “like-kind” investment property. With a 1031 exchange, the proceeds from the sale of your old property roll right into your new property. You don’t have to pay taxes on these proceeds because you don’t actually receive them. Deferring these taxes allows you to grow your portfolio and net worth faster.
- Consult with a financial advisor. A financial advisor will be able to review your unique financial situation and help you explore additional options for minimizing your capital gains taxes.
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