In this lesson we are talking about Capital Gains – what capital gains are, how they are calculated and how they are paid. We will also be talking about how you could potentially reduce those capital gains over time saving you money!
Capital gains are essentially the gain in value on real estate, it does not really matter if that real estate is something you own as a primary home or an investment or commercial property. With any type of real estate, the gain is simply the difference between what you sold the property for minus your purchase price and any capital improvements you made while you owned it. So if you bought a home for $200,000 and you sold it for $400,000 that’s a $200,000 gain. However, if you put $100,000 dollars of improvements into it then your gain is only $100,000, and you can subtract the cost of sale from the gain.
Capital gains are due to both the State and Federal government, when you file your income taxes for the year in which you sold, typically the next year. However, in some states, like California, at the closing of the sale, they require a portion of the possible tax to be held back and remitted to the State, just in case you owe taxes. There are possible exemptions to this holdback, just know that it can happen when you sell real estate.
There are different considerations if the property you sold was your primary residence or an investment property. There are different tax rates for long-term and short-term gains. Long-term is anything more than one year, short term is less than 12 months – no difference if primary home or investment property. Long term capital gain tax rates are typically lower than short term tax rates. Note that these taxes are often high on the list of taxes being reviewed at all levels of government as a source of additional revenue and ballot measures adjusting these taxes are on the ballots around the country often.
There are a few strategies you can consider reduce your capital gain tax bill and you should always consult with your CPA or tax professional.
On the sale of a Primary home the current tax law set up that there is a $500,000 exclusion for a married couple and $250,000 exclusion for a single person. This means that if you buy a home for $500,000 and you sell it for $1,500,000 and you are a married couple, you have a $500,000 exemption. So normally that would be a $1,000,000 gain but because of the $500,000 exemption, you only have a $500,000 gain, that you may own tax on – unless you have capital improvements into the home that can be documented. If you are a single person then it is $250,000.
An additional benefit in some cases is what is called a “Stepped Up Basis”. This applies when one of the spouses that jointly owned real estate dies, the remaining spouse gets what is called a step-up in basis. So, if the home was purchased for $200,000 and then one of the spouses died a few years ago and it is now worth $400,000, the new basis of the home for capital gains tax calculations is now $400,000. This step up only applies to a primary residence jointly owned by a couple.
In investment properties there are a couple of different tax mitigation options – again you want to get with a tax or investment professional to make sure you are up to speed on all current laws. A 1031 exchange is very commonly used tool. 1031 is the IRS code section that allows you to defer the capital gain by purchasing another piece of real property and moving the gain into that property. There are all sorts of strategies within the 1031 exchange program – it does not have to be the exact same type of property. There are strategies to sell an individually owned property and purchase a share in what is called a tenant’s in common exchange. You can also be selling a single-family home and buying a commercial property or from a commercial property to multiple units. The bottom line is that you defer your taxes into another real estate type of investment.
A charitable remainder trust (CRT) is a trust you create, that allows you to put highly appreciated real-estate into a trust and the Trust pays you income over your lifetime. When you die the remainder of that trust goes to the charity, you selected within the Trust. And this is just one of the advanced strategies that are out there – the more the gain, the more sophisticated the strategies that could help you mitigate the taxes owed. You would ideally, work with a planning professional in the tax/estate/trust or investment field if you are lucky enough to have a huge capital gain and wanted to explore tax reduction strategies.