“In this world, nothing is certain except death and taxes.” -Benjamin Franklin
The inevitable tax bill. Any time you make a dime, the government wants a cut, except for capital gains on the sale of your home. Capital gains exemptions are tax advantages designed to encourage people to grow their personal wealth through buying a home. When you play the tax game right, you can save a ton of money by understanding capital gains taxes and how this can affect your real estate transaction.
True to tax law standards, capital gains laws aren’t entirely straightforward. There are many different caveats and special circumstances. It is always a good idea to consult a tax professional about your unique situation to get an accurate idea of how capital gains apply to the sale of your home.
If you are a homeowner in Washington, D.C., this is a basic overview of how you can use capital gains to maximize your investment. These rules apply to a variety of transactions, whether you are selling to cash home buyers in Washington, DC, to traditional buyers with financing, or to someone who advertises, “We buy houses in Washington, DC.” Regardless of who you sell your home to, you, as a homeowner, can take advantage of these lucrative tax laws.
What is Capital Gains Tax?
A capital gains tax is a tax on the “gains” of the value of your home. In short, this means you pay a tax on the difference between what you paid for your home and what you sell it for. For most of history, any time you made a profit off the sale of a home, you were taxed on that money. In 1997, everything changed, creating an opportunity for homeowners to avoid paying taxes on the proceeds from the sale of their homes if they met certain conditions.
Selling a home can be lucrative. For many people, it defines a large portion of their net worth. As market values go up and equity in the home increases, so does the amount of money you stand to gain when you sell. Because it’s not uncommon for a homeowner to make tens to hundreds of thousands of dollars when they sell, a capital gains tax can add up to a lot of money. It pays to understand how the tax works and how to avoid it to keep that money in your own pocket.
Are There Different Types of Capital Gains?
There are two different categories of capital gains. The length of ownership will determine which category a transaction falls into.
1. Short-Term Capital Gains:
Homes that are bought and sold within 1 year are subject to short-term capital gains. The IRS will count the proceeds as regular income, and the top marginal tax rate of the owner’s tax bracket will determine the taxes owed. This can range anywhere from 10% to 37%.
2. Long-Term Capital Gains:
After 1 year, the sale of a home becomes eligible for long-term capital gains. The tax rate for most long-term capital gains is 15%, but circumstances can potentially push it as high as 20% or as low as 0%. The tax break for holding onto a property for over a year can be significant.
What Does it Take to Avoid Capital Gains?
While there are tax breaks for holding onto a property for a year, holding onto it for two means you might avoid paying capital gains altogether. Homeowners are eligible to qualify for a capital gains exemption every 2 years, provided they meet the other qualifying criteria:
- If you are filing as single, you are exempt from capital gains on the first $250,000 in profits.
- If you are filing as married, you are exempt from being taxed on the first $500,000 in profits.
-IF-
- You have owned the home for at least 2 years.
- You have lived in the home for 2 of the last 5 years (does not need to be consecutive).
Are There Any Other Ways to Be Exempt From Capital Gains?
Special circumstances often broaden the rules of capital gains. Rules exist that allow people in exceptional situations a way to avoid this pricey tax.
- Military families, peace corps members, and even the police force have more lenient requirements to qualify for capital gains exclusions.
- A 1031 exchange allows you to bypass a capital gains tax by rolling profits into a similar property.
- Using your property as a rental instead of selling it can delay the need to pay a capital gains tax.
- You can deduct certain expenses from the proceeds to minimize the tax. Upgrades, repairs, closing costs, loss of income due to tenant issues, and selling fees can be considered expenses you paid into the home’s value. If you can adequately document these expenses, you can lower the amount you will pay taxes on.
- The IRS has special considerations for certain circumstances that might help you avoid capital gains. People who are forced to relocate because of their jobs, or who need to move to seek medical treatment, victims of natural disasters, terrorism, divorce, death of a co-owner, or drastic loss of income are often able to obtain an exemption to capital gains.
Are You Required to Pay Capital Gains on a Rental Property?
If you are selling a rental property, you are required to pay capital gains on it. You can avoid this tax by living in it for 2 of the past 5 years, or you can wrap your profits up into a 1031 exchange and use them to buy another property.
Capital gains exemptions are an incredible benefit for homeowners. It is a tool that can help maximize the investment that you have made in your home. Understanding the rules and timing your sale right can help you keep more of the money you make from the investment in your home.