Selling highly appreciated real estate can be a significant financial windfall for real estate investors and property owners.
It also can leave you with a significant capital gains tax liability. There is a capital gains exemption for selling certain real estate. Let’s take a closer look.
Capital gains taxes can take a hefty chunk of your profits when you sell real estate that’s increased in value from your original basis. It’s important to look ahead and consider the impact these taxes may have on your potential profits when selling real estate.
Short-term capital gains – assets sold for profit that you held for less than one year – are taxed at your nominal tax rate, which could be as high as 37 percent for people whose income places them in the highest tax bracket. At that tax rate, you would have a $185,000 tax liability if you sold a property held for less than 12 months for $500,000 more than your adjusted costs basis.
Long-term capital gains – assets sold for profit that are held for a year or longer – are taxed more favorably at 0, 15, or 20 percent depending on your income and filing status. Capital gains taxes on the sale referenced above would be $75,000 (15%), or $100,000 (20%), or zero, making hold time an important tax strategy.
For investors who own commercial real estate assets, one way to defer capital gains taxes is to complete a 1031 exchange where you roll over the entirety of your sale proceeds into a like-kind replacement. Investors who have a hard time finding suitable replacement properties can also complete their exchange by purchasing beneficial interests in a Delaware Statutory Trust in the exact amount needed to satisfy their exchange requirements.
These strategies are primarily for investors who own income-generating investment properties. There’s another strategy that can be a huge benefit when selling certain residential real estate.
You may be able to avoid generating any capital tax liability when selling your primary residence due to an allowable IRS exclusion, provided you meet certain criteria.
If you lived in your home for two of the past five years preceding the sale, you qualify for a capital gains exclusion of $250,000 for single filers and $500,000 for married joint filers. You’ll have to demonstrate that the home was your primary residence and that you lived in it for at least two years, but the primary residence rule doesn’t have to be consecutive. If you lived in a home for a year, rented it out for three years, and then returned to live in it one more year, you would qualify for the exemption.
You also could claim the capital gains tax exclusion on a rental, vacation, or second home, provided you convert the property into your primary residence and live in it for at least 24 months. This important tax exemption is only allowed once every two years.
Commercial real estate investors have a few strategies they can deploy to lower or defer capital gains tax liabilities when selling investment real estate. Homeowners, meanwhile, may enjoy a one-time capital gains exemption when selling their homes.
Homeowners who make less than $250,000 (single filers) or $500,000 (married joint filers) of profit on the sale of their homes won’t have to pay any capital gains taxes provided the property was their primary residence and they lived in it for at least two years. Consult with a taxation professional for more insight into how this exclusion applies in instances of divorce or for military personnel.