Whenever you sell any type of asset for a profit, the extra amount is often referred to as capital gain, and the profit is taxable in most cases. Since the taxes are based on capital gains, they are commonly known as capital gains taxes. If you are selling a house or you’re a real estate investor, it’s essential to understand the concept.
Here are some important aspects you ought to know about property capital gains for selling a house.
Understanding the Cost Basis
The cost basis comprises the house’s purchase price, acquisition-related expenses, and cost of property improvements. On the other hand, the profit is derived from differences in cost basis and sale price of the property. In most cases, the purchase price and cost basis are different.
However, there are some exceptions. For instance, if you inherit a property, the cost basis is equivalent to the market value at the date of death. To illustrate further, if your parents bought a property at $10,000 a decade ago and you inherited when the market value was $100,000, the later amount is the cost basis.
With rental properties, you can claim a depreciation expense. While this lowers taxable income, it also reduces the property’s cost basis, and when you decide to sell the property, you must pay depreciation recapture to the IRS.
Capital Gains Tax Exemptions
While capital gains apply to almost every property, there are notable exceptions. The first one allows you not to pay a certain amount when selling a primary residence. The other one lets you defer the taxes after selling a property.
1. Primary Residence Exclusion
If you sell your home, you can use the primary residence exclusion rule to avoid paying taxes on the capital gains. Typically, you can avoid paying up to $250,000 of your property sale profits. However, if you file the returns with your spouse, you can exclude up to $500,000. To become eligible for the exclusion, you have to meet two conditions:
· Own the home for two years out of five prior to the sale
· Must have resided in the house for two years before selling
These conditions may not necessarily be in two consecutive years. However, you can’t leverage the exclusion rule if you have excluded gains from another property in the last two years.
2. 1031 Exchange
Investors often pay taxes for property sale profits and depreciation recapture. As such, they can be met with a huge tax bill every time you sell a house. However, you can use the 1031 exchange rule to avoid paying taxes on profits from a property sale.
The 1031 exchange rule lets you defer accrued taxes from the property sale. You do this by using the money to acquire another property. As long as you use the proceeds as re-investment capital, you can leverage the 1031 rule indefinitely. However, the new property should bear a similar value as the one you just sold.
Real estate capital gains taxes can get complicated compared to other assets. Since there are numerous scenarios that can further complicate the concept, it’s prudent to consult a professional and discuss your specific issue.
Thanks to slghomebuyer.ca for consulting.