You’ve finally done it — you’ve sold an asset that provided substantial profits. Before you start celebrating, however, there is one more question you have to keep in mind: how much of your hard-earned money do you actually get to keep?
This is where capital gains tax comes in — the bane of many investors, taking away a chunk of their earnings if they weren’t prepared for it.
At Realized 1031, we want to help investors — newbies and seasoned ones alike — gain a better understanding of cap gains tax to help you maximize your earnings. Let’s dissect and examine this type of tax liability so you’ll learn the rules and how you might be able to save.
What Is Capital Gains Tax? A Comprehensive Overview
Capital gains tax is the tax you pay for any type of capital gain. This gain is the increase in the value of a capital asset when it’s sold. As a refresher, a capital asset is any asset you own that has significant value — when you sell it for a profit, you may need to pay capital gains taxes.
Here are common examples of capital assets:
- Stocks
- Bonds
- Real estate
- Vehicles
- Equipment
- Land
- Collectibles (such as art, antiques, and coins)
- Business interests
In the realm of investing, the original purchase price of these assets is called the basis. The difference between the basis and the selling price is the capital gain or loss. Under IRS rules, a gain is subject to taxation, with rates distinct from ordinary income.
Types of Capital Gains
The two types of capital gains mainly differ based on how long you hold an asset.
Short-term Capital Gains
A short-term capital gain occurs when you sell an asset you only held for one year or less. The IRS recognizes this type of gain as ordinary income and thus follows regular tax rates. Based on your tax bracket, you could pay as much as 37% of capital gains for this category.
Long-term Capital Gains
On the other hand, long-term capital gains are the profit you realize after selling an asset you held for more than a year. These gains use another set of rates, which are lower than short-term capital gains. The highest rate is 20% in most cases, but certain types of gains are taxed as high as 28% in some instances.
Federal-Level Tax Rates
The IRS is the federal-level revenue agency that taxes capital gains. This distinction is essential because state-level revenue departments may also require you to pay capital gains taxes. As of 2024, these are the federal tax rates.
- 0% Rate: Single people earning up to $47,025 and married couples (filing jointly) earning up to $94,050 in personal income don’t have to pay any capital gains taxes.
- 15% Rate: Single taxpayers who earn between $47,025 to $518,900 and married couples who earn between $94,050 to $583,750 in income must follow the 15% tax rate.
- 20% Rate: Married couples earning more than $583,750 and single people earning above $518,900 must pay 20% in taxes.
State-level Tax Rates
Each state’s capital gains taxes are unique to its jurisdiction. As of 2024, the state with the highest rates is California, taxing up to 13.30% of the realized gains. Some don’t tax capital gains at all, but they do have certain stipulations that may affect your tax payments. These states include:
- Alaska
- Florida
- Nevada
- New Hampshire
- South Dakota
- Tennessee
- Texas
- Wyoming
For a more comprehensive idea of each state’s capital gain tax rates for 2023 and 2024, check out our guide.
How Does Capital Gains Tax Work?
On a federal level, two things determine how much capital gains tax you have to pay after selling an asset for a profit. First is whether the capital gain is short or long-term, and the second is your tax rate. In this discussion, we’re going to focus on real estate assets.
The first step is knowing how much capital gains you’ve earned. Follow this formula.
Capital Gain = Selling Price – Cost Basis
Selling Price: This is the amount you receive after selling the real estate property.
Cost Basis: The basis is the original purchase price of the asset. This value may also include associated costs, such as improvements or transaction fees, which diminish your earnings.
Let’s say you owned a $1 million property. This year, you sold it for $2.5 million after learning about favorable market conditions. Your capital gain was $1.5 million, and it’s subject to taxes.
How much do you owe the IRS for this tax year after selling the property?
Short-term Capital Gains
For assets you held for less than a year, the taxes you need to pay can be as high as 37% since the realized gain is considered as regular income. Let’s say that you belong to the highest tax bracket and will need to pay the maximum rate.
In our example above, let’s say you were able to sell the $1 million property for $1.6 million after just 11 months of ownership. The capital gains in this case is $600,000.
Capital Gains ($600,000) x Tax Rate (0.37) = Capital Gains Tax ($222,000)
You will need to pay $222,000 to the IRS if you realized gains on the $1 million property you owned for less than a year.
Long-term Capital Gains
The highest tax rate for long-term capital gains is 20% as of 2024. Let’s follow the example above, but this time, you were able to sell the property for $2.5 million after owning it for 5 years. You belong to the highest tax bracket, so the calculation for your capital gains tax would be as follows.
Capital Gains ($1,500,000) x Tax Rate (0.20) = Capital Gains Tax ($300,000)
If you were only able to sell the property for $1.6 million instead of $2.5 million, then the capital gains taxes would only be $120,000. As such, it’s important to create the distinction between short-term and long-term capital gains. The latter has lower rates because it provides an incentive for investors to hold properties for a longer period. This practice helps make markets more stable and avoid volatility.
How To Report and Pay Capital Gains Taxes
You need to report your capital gains on your annual tax return on the same tax year you made the sale. On Schedule D (Form 1040), you’ll need to list all sales and calculate your net gain or loss. For the real estate sale itself, you’ll need to provide details like the date you bought and sold the asset, the purchase and sale prices, and any associated costs that affect your cost basis.
Netting Gains and Losses
Investors can take advantage of a practice called netting, where they can combine both gains and losses to offset them against each other. You may be able to find losses that reduce the amount of your gains, which then potentially reduce your tax liability. For example, if you have a loss of $100,000 and a gain of $300,000, then you may only need to pay taxes for the remaining $200,000 net gain.
Carryover Losses
There are cases when your losses exceed your gains. In this instance, you can carry over these losses to future years and offset your gains annually. This strategy can be particularly useful in reducing taxable income over time, providing a long-term tax benefit.
These two strategies above are methods of reducing capital gains taxes as you file your return, though there are other strategies available to real estate investors, and we’ll discuss them later.
Other Special Considerations To Keep in Mind
Here are a few other factors that may affect your final capital gains tax payments.
Depreciation Recapture
When an asset depreciates over the years yet you still sell it for a gain, the IRS will get back the taxes in a process called depreciation recapture. The value will be taxed as regular income, which has a higher maximum rate than the cap gains tax rate.
Net Investment Income Tax (NIIT)
If you’re a high-income earner, you may be required to pay NIIT on your net investment income, which includes capital gains. The rate is 3.8% for the lower value of either: your net investment income or by how much your modified adjusted gross income (MAGI) exceeds the specific income threshold you belong to.
Rates for Collectibles
For those who are selling collectibles like artwork and antiques, the cap gains tax rate may reach up to 28% — higher than the standard percentage. This increase is meant to recognize the potential high-value appreciation of such assets.
Strategies That May Help Minimize Your Capital Gains Taxes
As you may have seen from our examples above, capital gains taxes can eat up a substantial amount of your earnings. As such, it’s important to employ strategies that help defer, reduce, or eliminate your tax liabilities. Here are some popular approaches that many seasoned investors leverage.
1. Prolonging the Holding Period
The rates for long-term capital gains are lower than short-term capital gains. It makes sense to hold your assets for more than a year at the minimum to enjoy the lower rates. Plus, there’s a chance that the asset will appreciate the longer you hold, leading to potentially higher capital gains.
2. Tax-loss Harvesting
Netting and use of carryover losses fall under the category of tax-loss harvesting. This is the process of using your losses to offset your capital gains and reduce the taxable amount. There are more deliberate strategies you can use, such as selling another asset at a loss to reduce your overall net gains. However, this strategy can be tricky, so you may want to seek the guidance of tax and financial experts.
3. Selling Your Primary Residence
You can avoid paying capital gains tax up to a certain point if you sell your primary residence and buy a new house. This is called the Section 121 Exclusion, which benefits both individual and married homeowners. For single taxpayers, you may exclude up to $250,000 and pay capital gains tax on the remaining amount. The same goes for married couples, but the threshold is at $500,000.
For the IRS to recognize the property as your primary residence, you must comply with these requirements.
- You’ve owned the home for at least two of the last five years.
- You’ve lived in the home for at least two of the last five years.
- You haven’t claimed any capital gains exemption for another residence within the past two years.
There is another way to manage capital gains through the sale of a home, especially if the property does not qualify as a primary residence and is instead an investment property. However, this sale is more of a “swap” and allows you to defer capital gains tax payments for an indefinite period. We’re referring to 1031 exchanges, which we’ll discuss further below.
4. Invest in Tax-Deferred or Tax-Exempt Accounts
A few types of savings accounts can help you avoid paying capital tax gains until you withdraw the funds. Two well-known ones are an IRA (Individual Retirement Account) or 401(k). Your investments can grow tax-free in the meantime. In the future, you may even belong to a lower tax bracket, which also lowers your tax rates.
5. Gifting the Assets
In estate planning, gifting assets to family members can be a tax-efficient strategy. Since you made no sale, the recipient instead assumes the cost basis of the property as well as the holding period. If your heir is in a lower tax bracket, then the capital gains they’d earn if they sell your property will be taxed at a lower rate. This practice can potentially lower tax liability by thousands.
There’s also the practice of gifting an asset in increments. Gifting up to $18,000 (as of 2024) annually helps you avoid gift tax. Thanks to this practice, you can reduce your capital gains tax and estate tax liability over time.
6. Timing Your Sales for Maximum Tax Benefit
Strategic timing can help you minimize capital gains taxes. For example, you can plan the sale of a real estate asset during a year when you expect your taxable income to be lower. This can be the year when you anticipate a step down in your tax bracket or during retirement.
7. Trying Alternative Investment Options
Deferring capital gains taxes is a way to preserve your capital and address the liability at a later, more convenient time. Aside from investing the proceeds of a sale into a retirement account, you can try alternative investment options to defer tax payments. Some of the most popular options are 1031 exchanges, Delaware Statutory Trusts (DSTs), and Opportunity Zone Funds. Here’s what you need to know about each one.
1031 Exchanges
A 1031 exchange, also known as a like-kind exchange, takes advantage of Section 1031 in the IRS Revenue Code. This provision allows real estate property owners to exchange their properties for a similar one to defer tax payments. Since no sale occurred, no gain was realized. In theory, you can continue deferring capital gains taxes for as long as you keep swapping one like-kind property for the next.
Once you do sell the property, only then will the transaction trigger a taxable event. By this time, you should have already grown your initial capital through appreciation and other investments. That way, you’d have enough funds to confidently pay your tax liability.
The biggest drawback of a 1031 exchange is the strict IRS rules and guidelines that every investor must follow when doing a 1031 exchange. Failure to comply with these regulations can result in disqualification from the tax deferral, making you liable to pay taxes during the sale. Some rules you must adhere to are the following.
- 180-day Period: The entire exchange must occur during the prescribed 180-day period, including identifying the like-kind property and its acquisition.
- Qualified Intermediary (QI): You will need to work with a QI, the entity that oversees that entire 1031 Exchange and ensures that the transaction is following IRS guidelines.
- Same Taxpayer: The taxpayer that relinquished property must also be the same taxpayer that acquires the new one.
- Greater or Equal Value: The property you’ll need to acquire must be of the same or greater value than the property you relinquished. Otherwise, you will need to pay taxes on the remainder of the proceeds as capital gains. In relation to this rule, the IRS requires that you reinvest all the proceeds of the sale into the new property. You can’t take out a percentage for other purposes.
- No Personal Property: Investors must only exchange properties to be used for investment purposes, not for personal residence.
Delaware Statutory Trusts
Even with the six-month timeframe provided by the IRS, investors may still find it hard to find a like-kind property that’s close to the value of the asset they’re trying to relinquish. Other investors may have different goals in mind apart from capital gains tax deferral, such as less involvement in the acquired real estate asset — an advantage that you may not get in a traditional 1031 Exchange.
DSTs solve these two problems. This type of investment vehicle lets you sell your property and use the proceeds to buy undivided fractional interests in a trust, which is the entity that actually handles the investment.
Thanks to this structure, investors won’t have to find a like-kind property that’s close to the value of the one they’re about to sell — they can simply join the DST by purchasing the interests along with other investors. The sponsors, which handle the operation and administration of the DST, pool the funds to replace the capital they used to purchase the property. After enough investors have entered the DST, the property can begin making profits through rental income or appreciation.
Given how the sponsor handles the management of the property, investors won’t have to be involved in the decision-making aspect of the property. They can reap the profits (in incurred) and follow the holding period, which is usually five to 12 years in DSTs. The illiquid nature of a DST can be a drawback, but after this timeframe, investors can reinvest their interest in another DST to continue deferring taxes. Another option is to cash out, but this will trigger a taxable event. If you take the latter route, only then will you need to pay capital gains taxes. One other drawback is that DSTs can have higher fees than traditional investments, so do your research before jumping into a DST.
Opportunity Zones
The Opportunity Zone program is another method to defer — and potentially eliminate — capital gains taxes. Thanks to the Tax Cuts and Jobs Act, designated census areas all over the U.S. and its territories gain a Qualified Opportunity Zone status. People who invest in these zones enjoy various benefits while also spurring the economic growth of the area.
As an investor, one quick way to participate is to join a Qualified Opportunity Fund (QOF) to invest in the Opportunity Zone. The QOF serves as the investment vehicle where investors pool their resources to provide resources for real estate developments, equipment purchases, and small business capital. Once you’ve invested your proceeds into the QOF and a qualified opportunity zone property (QOZP) has met the requirements, taxes on capital gains can be deferred until the sponsor sells the property or on December 21, 2026.
There is a way that you could potentially eliminate all your capital gains taxes from your previous sale. QOZPs have a holding period of 10 years. During this time, all capital gains from the QOZP during the holding period will remain nontaxable because the cost basis of the QOZP will be deemed equal to its fair market value. In other words, no appreciation resulted in gain. If you were able to hold on to the QOZP for a decade, the IRS will no longer consider any capital gains from your previous property. Thus, no more tax liability.
These tax advantages are meant to entice more investors to provide much-needed capital to distressed communities in the U.S. By joining a QOF, you’re not only diversifying your portfolio and gaining tax benefits, but you’re also helping encourage growth in various U.S. areas, which may help you reach your philanthropic or sustainability goals. However, because these investments are in less established areas and are “ground-up” developments they tend to have a much riskier investment profile than an established investment.
Deferred Sales Trust
There’s another “DST” that investors can leverage to manage their capital gains tax payments. A deferred sales trust combines elements from a Delaware Statutory Trust and installment sales. First, the investors find a third-party company that serves as the trustee. Then, the investor will sell the property to this trust. The trust sells the property to another entity and holds on to the proceeds. Over time, the trustee sends the funds in installments to the original seller.
Since a sale is made when using a deferred sales trust, the investor will have tax liability. However, the installment model helps them avoid lump sum payments in a single tax year. The tax liability is instead spread out over a few years. This advantage makes capital gains tax payments more manageable.
There are a few advantages that make this DST the preferred option for some investors. First, there is no “like-kind” restriction that is required for both traditional 1013 Exchanges and Delaware Statutory Trusts (and to a certain extent, QOFs). The trustee has free reign on where to invest the proceeds from the sale of your property. Plus, there’s also added flexibility from the fact that deferred sales trusts don’t have timeframes.
Of course, deferred sales trusts are not for every investor. Some disadvantages may make this strategy riskier for some individuals. One example is the complexity of creating the trust. Consulting with tax professionals and legal experts becomes an essential step when creating a deferred sales trust.
In connection to the complexity is the expense that comes with establishing and maintaining the trust. This challenge could easily erode your profits, potentially leading to lower payouts than you anticipated.
These four alternative investment strategies are just a few of the possible approaches you can take to defer taxes. With the exception of Opportunity Zones, all these will require you to pay capital gains tax eventually. Your liability is deferred — not eliminated. In other words, you’re still on the hook for taxes for reinvested capital gains.
While we’ve listed some of the key benefits and risks of these alternative investment options, make sure that you have a thorough understanding of the risks, processes, and possible outcomes. That way, you can proceed with confidence and avoid making mistakes that could lead to disqualification from the tax benefits. We recommend working with tax professionals and financial advisors to get the guidance you need.
Additional Rules and Exemptions in Capital Gains Tax
Several other rules and exemptions exist that may make capital gains tax even more complex than it already is. As such, it’s critical for investors like you to understand these other guidelines to make tax management easier. Here are additional considerations to keep in mind.
2-out-of-5 Rule
We’ve already mentioned some of the requirements for selling a primary residence and claiming some capital gains tax exemptions. One of these is the 2-out-of-5 rule where you can only classify a property as your main residence if you’ve lived there within two of the last five years. These two years don’t have to be consecutive. So, if you lived in a property in 2020 and then again in 2022, you could still qualify for the exemption in 2024. Another example would be if you rented the property for three years and only lived in it for two. You can still enjoy the home sale exclusion if you only returned for the sale.
If you don’t fit these requirements, you may still be qualified for a partial claim based on the time you lived on the property and if other unique circumstances happened to you that necessitated a move. These include the following.
- Work or profession-related move
- Health-related move
- Unforeseen events such as death, destruction of the home, or becoming ineligible for unemployment benefits.
International Rules on Capital Gains Tax
It’s not uncommon for high-net-worth individuals to have properties abroad. If you’re one of them, it’s also important to consider these tax liabilities and see how they compare with U.S. rules. For example, while the maximum tax rate for real estate sale capital gains in the country is 20%, countries like Denmark can go as high as 42% — nearly half of your total proceeds! Other countries, like Belgium and Luxembourg, don’t have any capital gains tax at all.
There are also other time frames in countries like Australia, which follows a six-year rule for home sale exclusions for primary residences instead of the 2-out-of-5 rule. This exemption works a little differently than the U.S. because Australia actually grants full capital gains tax exemptions for the principal place of residence. The six-year rule, instead, means that the owner can still claim the exemption for up to six years if they move out of their residence and rent it out.
Foreign Investors and Their Tax Obligations
Given the thriving economy of the U.S., it’s not surprising that many foreign investors want to put their capital in various U.S. investments and enjoy the profits. Since they’re making a profit out of the country’s sources, foreign investors must pay capital gains taxes to the U.S. when selling an asset like stocks, right?
Kind of…according to the IRS, “The disposition of a U.S. real property interest by a foreign person (the transferor) is subject to the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) income tax withholding. FIRPTA authorized the United States to tax foreign persons on dispositions of U.S. real property interests.”
Age Exceptions: Are People Above 55 Exempt From Paying Capital Gains Tax?
No. However, the answer used to be yes when the Over-55 Home Sale Exemption was still a legal provision. Back then, people above 55 were able to enjoy a tax break on the sale of a home. This provision ended in 1997 when broader homeowner exemption policies replaced it. Instead of just people above 55, everyone can now enjoy potential tax breaks from the capital gains taxes. So, as long as you meet the specific residency and ownership requirements we mentioned, then you can join the tax exemptions.
Congress does have a tendency to refine or modify tax provisions frequently. This practice coupled with outdated beliefs has resulted in confusion among taxpayers. As such, it’s important to consult with your accountant or tax professional to learn about the latest provisions and how these could affect your tax planning.
Is there a certain age when you no longer have to pay taxes? This is another common question that’s a vestige of the outdated Over-55 Home Sale Exemption provision. The answer is: no. The IRS doesn’t determine whether or not you have to pay capital gains taxes based on your age. No matter your seniority, you will still need to pay capital gains taxes upon making a profit on the sale of an asset.
Another age-related question is if your age affects how much you pay in capital gains taxes. This time, the answer is more complex. In most cases, the same principle applies: your age won’t affect how much you’re going to pay in cap gains taxes. Things do change upon your retirement, where most investors have lower income and thus belong to a lower tax bracket. You may pay a lower percentage compared to when you were working and still earning. As such, age can have an effect on how much capital gains taxes you will pay.
Capital Gains Exemption for Inherited Assets
Apart from gifting your assets to loved ones to defer tax payments, there is another exemption you can employ to potentially eliminate capital gains taxes: the step-up in basis for inherited assets. According to the IRS, the cost basis of an inherited property is “stepped up” to the asset’s fair market value. This is similar to the mechanism of the QOZP. So if the heir sells the property immediately, they may owe little to no capital gains tax since technically, the asset hasn’t appreciated at all. There’s essentially a reset.
Capital Gains and Your Tax Bracket
One concern that many newbie investors may have is whether capital gains will put them in a higher income tax bracket or not. After all, your net worth may increase given significant gains, which logically means you’re moving to another tax bracket if you earn more than your current bracket’s threshold.
The answer is no, your tax bracket won’t be affected by how much profit you make after selling a capital asset. That’s because capital gains and regular income are treated under separate tax classifications.
As we mentioned above, the IRS has distinct rates for ordinary income and capital gains. This is the first indication that capital gains won’t affect your tax bracket. The IRS considers income from the predetermined sources as ordinary income.
- Wages and Salaries
- Self-Employment Income
- Interest Income
- Dividends
- Rental Income
- Retirement Income
- Alimony (for agreements prior to 2019)
- Unemployment Compensation
- Social Security Benefits
- Short-Term Capital Gains
- Gambling Winnings and Prizes
- Debt Forgiveness
These are the only types of income that can be charged by up to 37% in ordinary income tax. Why are capital gains, specifically long-term capital gains, not included in the list?
There is a valid reason for this exception. The government treats capital gains differently — that is, at a much lower rate — to encourage people to productively invest their money. The lower rates mean people enjoy more savings that they can then use as capital for other types of investment. High tax rates will deplete taxpayer resources too much, which isn’t healthy for the economy. This motivation also explains the distinction between short and long-term capital gains. Holding on to assets for longer helps stabilize the market and avoid constant volatility, leading to stronger economies.
Even so, your net capital gains can still affect your overall tax liability. So, even if you’re in a lower bracket but somehow were able to earn considerable capital gains after a sale, the amount you pay will still be significant. In contrast, if your net capital gains are negative, they may offset your ordinary income, potentially reducing your overall tax liability.
What About Taxpayers With High Net Worth?
We’ve mentioned above how high-income earners will need to pay NIIT. Those who make significant earnings on their net investments, which include capital gains, can expect to pay 3.8% additional on top of the 20% tax rate they’re already paying.
To determine if you’re a high-income taxpayer, here’s the latest chart detailing the modified adjusted gross income or MAGI. Past these amounts, you’ll be subject to NIIT.
- Single/Head of Household – $200,000
- Married Filing Jointly – $250,000
- Married Filing Separately – $125,000
- Qualified Widow/Widower with Child — $250,000
Keep in mind that MAGI is not the same as your adjusted gross income or AGI. The former is the calculation of your income after certain deductions and tax exemptions have been applied. These include retirement account contributions and Child Tax Credit. Thanks to MAGI, your tax liability can actually go down.
Calculating NIIT is not as straightforward as simply multiplying 3.8% by your capital gains. Instead, the IRS either charges 3.8% on your net investment income or the amount exceeding your MAGI cutoff.
Let’s create an example. You’re a single investor who earned $250,000 in MAGI, and $25,000 of that was your net investment income (that you earned after selling a property). In this case, your income exceeds the $200,000 threshold by $50,000. Since your net investment income is $25,000 (less than the $50,000 over the threshold), you’ll only need to pay NIIT on the $25,000. The 3.8% tax on $25,000 would result in an NIIT of $950.
If you earned $75,000 in net investment income, then your NIIT would be based on the $50,000 you earned above your MAGI cutoff. In this scenario, your NIIT would be $1,900. This is no small amount, and those earning higher net investment income will potentially have higher tax liability. As such, it’s important to consider your NIIT payments as part of your capital gains tax planning. That way, you can avoid unexpected payments when tax season comes.
Strategies To Increase the Cost Basis
One immediate factor that automatically has an effect on your capital gains is the cost basis. While tax-deferred strategies and longer holding periods help manage capital gains taxes after the sale, increasing the basis helps decrease taxable gains before the sale itself.
Most guides simplify the basis as the price of the property when you acquired it in the past. However, other factors can increase the cost basis amount. With a higher cost basis comes a smaller margin between it and the final sales price, potentially reducing your capital gains taxes.
What are these specific factors that affect the cost basis? The most common ones are the expenses you incurred while selling the property. These include the following.
- Legal Fees
- Title Fees
- Survey Fees
- Renovations and Improvements
- Acquisition Costs
- Recording Fees
On the other hand, some expenses can actually decrease the cost basis. These include insurance payouts for theft or property damage. Calculating the difference between these expenses and payouts results in the final, adjusted cost basis.
One of the factors that you have the most control over is the renovations and improvements. The expenses for these activities can reduce your basis by a considerable amount. Of course, the IRS has set guidelines on what can be considered capital improvement. These are the changes that improve the overall value, increase the lifespan of the asset, and make it more livable for users (in the context of real estate properties).
Based on this description, repairs that you do because a component of the property is no longer working can’t be considered an improvement. One example is replacing leaky pipes. You didn’t make any substantial upgrades. You simply fixed damage caused by normal wear and tear.
However, if you built a new room, this could be considered a capital improvement. Other examples include the following.
- Installation of new decks and patios
- Building new driveways and paths
- Landscaping improvements
- Building a pool
- Upgrading the heating, ventilation, and air conditioning systems
- Installing built-in appliances
- Adding new windows and doors
- Installing solar panel systems
- Installing a security system
Many other upgrades can be included in this list. To ensure that you’ve covered every capital improvement you made over the years, make sure to consult with your accountant or tax professional.
Sample Calculation of Adjusted Cost Basis
Say you bought a property seven years ago for $300,000. This value serves as the original purchase price. Over the years, you made capital improvements that upgraded the functionality and aesthetics of your property. Let’s say that you did the following with their respective costs.
- Renovating the kitchen: $25,000
- Adding a new roof: $15,000
- Building a deck: $10,000
Overall, you spent $50,000 on capital improvements. The adjusted cost basis of your home is the sum of the original purchase price plus the capital improvements.
$300,000 + $50,000 = $350,000 (Adjusted Cost Basis)
For the sake of simplicity, we’re not including other expenses in this example.
Let’s then assume that you’re going to see your property this year for $550,000. How much capital gains taxes are you going to pay?
First, we need to subtract the adjusted cost basis from the sales price.
$550,000 – $350,000 = $200,000 (Capital Gains)
$200,000 x 20% (Assumed Tax Bracket) = $40,000 (Capital Gains Tax)
If you didn’t include your expenses and capital improvements to adjust the basis of your real estate asset, then you’ll only need to subtract the original purchase price from the sales price.
$550,000 – $300,000 = $250,000 (Capital Gains)
$250,000 x 0.20 (Assumed Tax Bracket) = $50,000 (Capital Gains Tax)
There’s a considerable $10,000 difference in capital gains tax between the two scenarios. This demonstrates the need to find these expenses and capital improvements to make an impactful reduction in your tax liability.
Inherited Stocks and Capital Gains Tax
We’ve explained above that inherited properties gain a stepped-up value that resets their basis, effectively removing capital gains from the predecessor. Is this advantage limited to real estate?
Let’s say that your uncle bought 100 shares of stock from a startup company in the 80s, each stock costing $10. He never sold them, and upon his death, the stocks went to you as he instructed in his will. Surprisingly, the company prospered over the years and each stock now has a value of $10,000. You now have around $1 million in stock. If your uncle sold them before his death, he would need to pay the huge tax liability.
Thankfully, the step-up in basis covers inherited stocks as well. You inherited the stocks at their current value, so you won’t have to pay capital gains taxes. If you do consider selling it immediately, then you may have a small liability should the stocks increase in value between the time you inherited them and the time you sold them.
This advantage applies to all inherited capital assets, not just stocks and real estate properties. Other types of assets that heirs usually inherit include bonds, mutual funds, and collectibles.
Farmland and Capital Gains Tax: Are Farmers and Ranchers Exempt?
In the past few years, farmland prices all over the U.S. have risen. As of 2021, Massachusetts saw an increase of 21% in farmland real estate sales — the highest in the country. Land in the state now costs $13,700 per acre. It’s not just Massachusetts that saw this increase. The previous per-acre average was $2,010, but the current has now increased to $3,380. There are several reasons for this increase, but the primary factor is the reduction of arable land in the U.S. As more and more areas develop into suburban and urban communities, the rates of farmland properties increase.
This rise in per-acre pricing has made farmland an attractive investment. Many farmers and ranch owners may consider selling their land to take advantage of favorable market conditions and realize considerable gains. Still, there are a few questions to ask, like “Is farmland exempt from capital gains taxes?”
The question is reasonable because many farmlands have been owned by the same family for generations. Many may not be aware of how much they might pay due to the steady appreciation of the land. Unfortunately, farmers are not exempt from paying capital gains tax after selling farmland. The property owner will still need to file and pay during the year the farm was sold.
Thankfully, there are strategies that farm owners can use to lower their tax liability. For one, they can adjust their cost basis by including capital improvements, such as the following.
- Corrals
- Outbuildings
- Barns
- Drainage Systems
- Fencing
- Wells
- Land Leveling
- Solar Panel
- Silos
Apart from adjusting the cost basis, farmers can leverage the tax deferral strategies we outlined above: 1031 exchanges, DSTs, and installment sales. However, these alternative investment options may be harder to pull off because, for example, it’s much harder to find like-kind properties if the farmer is planning a 1031 exchange.
What about inherited farmland? It’s not uncommon for farmland owners to bequeath their vast properties to their children and other beneficiaries. Thankfully, step-up in basis still applies to farmland. So, if you inherited a $10 million property that was $1 million 20 years ago when your parents purchased it, the basis would still be $10 million — no capital gains made and no tax liability to address.
If you do sell the farm eventually, let’s say in five years, then you may need to pay capital gains taxes as the farmland would have already appreciated by then. Still, the amount wouldn’t be that much in most cases. The longer you hold on to the property though, the higher its potential value to increase. In 20 years, you may need to pay hundreds of thousands in capital gains taxes eventually.
Here’s an example calculation for the example above.
Scenario One: You sold the farmland two years after inheritance.
Year 2024
Inherited Farm Basis: $1 million
Year 2026
Selling Price: $1.5 million
Selling Price ($1.5 million) – Basis ($1 million) = Capital Gains ($500,000)
Capital Gains ($500,000) * Assumed Tax Bracket (20%) = Capital Gains Tax ($100,000)
Scenario Two: You sold the farmland 20 years after inheritance.
Year 2024
Inherited Farm Basis: $1 million
Year 2044
Selling Price: $20 million
Selling Price ($20 million) – Basis ($1 million) = Capital Gains ($19,000,000)
Capital Gains ($19,000,000) * Assumed Tax Bracket (20%) = Capital Gains Tax ($3,800,000)
For the latter scenario, the tax liability is more than considerable. Employing tax deferral strategies becomes necessary to avoid having to pay such a huge sum. Otherwise, the farmer can simply let their children inherit the land and let them enjoy the benefits of the stepped-up basis.
Professionals To Work With for Capital Gains Tax Management
Managing capital gains taxes — and by extension, tax planning — can be a complicated process. One wrong move could have you paying hundreds of thousands in capital gains taxes, creating a major dent in your cash flow. Thankfully, you can work with to tackle the elaborate rules, processes, and considerations.
Accountants
Your CPAs are critical in helping you understand your tax liabilities and the processes of filing and paying them. For capital gains taxes, accountants have the skill and knowledge to help take advantage of every available deduction or deferral strategy.
Tax and Estate Planning Attorneys
The legal labyrinth of tax laws makes it important for investors to consider working with a tax attorney. These experts can help structure investments in a way that may reduce your tax liability and ensure that you’re following the guidelines and stipulations set by the IRS.
On the other hand, an estate planning attorney helps you structure your estate to minimize the capital gains tax burden for your heirs. These professionals also assist in implementing strategies like trusts or gifting to minimize your tax liability.
Financial Advisors
A financial planner or advisor helps with your short and long-term investment goals. These experts are knowledgeable in choosing the right strategies to help you minimize capital gains taxes. Plus, a financial advisor can help you determine when to sell or reinvest your profits for the highest potential of good returns.
Real Estate Professionals
Working with a real estate professional, especially for investment property transactions, improves the chances of a successful sale or swap. These experts can suggest improvements or strategies (such as a 1031 exchange) to defer or reduce capital gains taxes. Plus, real estate brokers have a wide network that lets you access other professionals, such as the ones we outlined above.
Alternative Investment Experts
If you are considering the tax-deferred strategies we outlined above, you will want to work with experts like us at Realized 1031. These exchanges, trusts, and other investment vehicles are intricate and have a lot of rules that require precision at every step. Having us guide you helps give you confidence that you’re taking the right course and that you’re handling every step of the process with accuracy.
Wrapping Up: Capital Gains Tax Rules 101
Capital gains tax is the looming specter haunting any capital asset sale. If you’re not prepared for this tax liability, you might be surprised by the considerable amount you’ll need to pay the IRS and even state revenue departments. That’s why careful planning and the right team of professionals are critical to help minimize your tax burden.
Understanding how capital gains tax is calculated and utilizing strategies like 1031 exchanges, DSTs, and installment sales can all potentially help you reduce your payments. We also recommend taking advantage of tactics like the use of capital improvements or step-up in basis to minimize or possibly eliminate capital gains tax. Overall, you’ll need to take a proactive approach to managing this tax liability and make significant savings.
For more details about capital gains taxes and alternative investment strategies you can try, schedule an appointment with Realized 1031 today!
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
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