Over the past few years, property values have soared. Homeowners around the country and in the most desirable New York Tri-State areas have experienced the thrill of competitive offers. Even if you had no plans to sell, watching your neighbors cash in, checking Zillow, or fielding unsolicited inquiries from aggressive buyers and agents may have piqued your interest.
But a word of caution: the excitement of navigating a real estate market in an era where homes fetch record prices can leave you vulnerable to emotional whims. While it’s possible that selling your home could be a lucrative opportunity, it’s prudent to consider every potential drawback before making a move.
When sellers are eager to access the proceeds of substantial equity returns, there’s one big ‘gotcha’ in particular that often escapes their attention: capital gains tax. The exhilaration of a high-value sale is undeniable, but don’t forget that the IRS will expect their share. You may be thinking, ‘So what if I have to give up a percentage of a windfall I wasn’t expecting?’ But knowing the rules and planning for them means you may be able to avoid paying more than necessary.
While the potential of paying capital gains tax shouldn’t prevent you from selling your home, it would be smart to become familiar with its intricacies. If you empower yourself with the knowledge of what to expect, you may be able to save some money and leverage your financial wins to your benefit.
Here’s what you should know to avoid being blindsided by an unexpected tax bill.
What Are Capital Gains Taxes?
Capital gains taxes are the taxes you must pay on the income you make from profit on an investment. If you sell your house for more than you paid, you can guarantee the IRS will want a cut. But the amount due depends on more than a simple calculation; it depends on your taxable income, filing status, and how long you owned the home (or other investment) before selling it.
To further complicate matters, every capital gains scenario is different.
Short-term capital gains, applicable if you held the property for a year or less, mirror your regular income tax rate and are dictated by your tax bracket. In this case, if possible, the ideal strategic move would be to sidestep short-term gains.
Long-term capital gains, on the other hand, offer more favorable taxation. Owning the property for over a year qualifies you to pay the long-term capital gains rate of 0%, 15%, or 20%, depending on your income and filing status.
It’s also important to note that in addition to capital gains tax, you may also have to pay state income tax on the profits, depending on your state’s tax laws.
Do You Qualify for a Capital Gains Exclusion?
Thanks to specific IRS exclusions, you can sometimes avoid excessive capital gains tax when selling your main residence. If you’re single, you can exclude up to $250,000 of capital gains from your taxes when selling a home. For married couples filing jointly, this exclusion doubles to $500,000. Keep in mind, though, that you can only use this exemption once every two years.
Understanding and leveraging capital gain exclusions can significantly boost the financial rewards of selling your property. It’s a tax-saving strategy that allows you to pocket a significant portion of your home sale profits without excessive burden.
Unfortunately, the exclusion doesn’t apply to every situation.
Unlocking the capital gains exclusion hinges on meeting all of these requirements:
- First and foremost, your house must have been your primary residence.
- You owned the property for more than two years
- You lived in the home for at least two years in the five-year period before the property is sold
- The property wasn’t obtained through a 1031 exchange (i.e., ‘like-kind exchange’) transaction.
- In the past two years, you haven’t utilized the capital gains exclusion for any other residential property.
Familiarizing yourself with these qualifiers is essential, as they delineate the scope of the exclusion and influence your ability to leverage its benefits during the sale of your property.
Understanding Capital Gains Scenarios
To help you better understand how various capital gains situations can play out, here are a few “real-life” examples. These stories showcase how a nuanced understanding of these intricacies can wield remarkable financial impacts on each seller’s life.
Scenario #1: Small Business Owner Avoids Capital Gains After Renting Out Her Condo
Courtney, who owns a successful small business, purchases a new condo for $300,000. She lives in it for a year and decides that she would like to move to a different neighborhood. Instead of selling her condo, she finds a couple to rent it. After three years, the couple moves out, and Courtney returns to her condo. She lives there for another year and decides to sell it. She sells it for $500,000 – a $200,000 profit. Because Courtney lived in the condo as her primary residence in two out of the last five years, and the profit did not exceed the $250,000 exclusion amount, no capital gains tax is due.
Let’s consider an alternate ending to Courtney’s story. Instead of moving back in after the tenants move out, Courtney decides to sell. At this point, she would have owned the condo for four years but only lived in it as her primary residence for one year. Because she did not meet all the exclusion requirements, but did at least own the home for over one year, she would have to pay long-term capital gains on her $200,000 profit. Depending on her tax bracket, this would cost her between $10,000 and $40,000—cash that she could have kept if she had lived in the home for one more year before selling.
Scenario #2: Grandparents’ Exclusion Nets 35% Tax Savings
Mario and Lisa are an older couple who have lived in their home for over 40 years. The neighborhood has changed dramatically, and they want to be closer to their children and grandchildren, so they decide to sell. They originally purchased their home for $80,000, now worth $1,500,000.
The total profit on the home sale is $1,420,000. As a married couple who files their taxes jointly, they qualify for the $500,000 exclusion. They will owe long-term capital gains only on $920,000 ($1,420,000 – $500,000), a more than 35% savings.
Scenario #3: Married Couple Makes a Costly and Preventable Capital Gains Misstep
Joseph and Olive are a young married couple living in the city and making a good living. During the pandemic, they decided they wanted to get out of the city for more space. They end up selling their condo, which they purchased for $300,000 five years ago, for $600,000. They do not owe any capital gains tax because the profit of $300,000 is under the $500,000 exclusion threshold. They find a home in the suburbs near the city for $550,000.
After nine months of living in their new home, they realize that the suburbs aren’t for them and want to return to the city. Because their neighborhood is so desirable, they are told they can sell their home for $700,000, $150,000 more than they paid less than a year ago. They decide to list, and the house sells almost immediately. Joseph and Olive think that no taxes will be owed because they lived in it, AND their profit is under the $500,000 threshold.
However, they cannot use the exclusion on this sale because they used it on the condo within the last two years. Not only that, they also owned the property for under one year, so they will have to pay short-term capital gains instead of long-term. The $150,000 will be taxed at their ordinary income tax rate on top of their other joint income of $300,000. Adding the $150,000 to their joint income would place them in the 28% federal tax bracket, meaning they would owe about $42,000 in taxes on their profits.
Let’s look at some alternatives Joseph and Olive could have taken. For starters, if they waited just three months to sell the home, they would have paid long-term capital gains rates (15%) on the $150,000 profit for a tax of “only” $22,500. This alone would have saved them $19,500 over the short-term capital gains tax.
If they could wait an additional 15 months to sell the home, they would have qualified for the exclusion again and paid no capital gains tax.
Of course, neither of these alternatives take into consideration whether the real estate market would have allowed them to sell their home for the same amount months later, but having all the facts about capital gains taxes can only help when deciding if and when to sell.
Scenario #4: Savvy Real Estate Investor Carefully Considers His Options
Jon is a contractor who flips houses on the side. He finds a great deal on a property in an up-and-coming neighborhood. He purchases the property for $350,000 and puts about $100,000 of work into it over six months. The property is now valued at $700,000; this would mean a profit of $250,000 ($700,000 – $450,000). Here are two possible outcomes for Jon’s sale:
Ending A: Jon sells the property for $700,000 and owes short-term capital gains on the $250,000 profit. He does not qualify for any exclusion because it is an investment property.
Ending B: Jon finds a tenant to rent the property for a year. The rent he receives covers his monthly costs (mortgage, taxes, etc.). After the tenant moves out, Jon would have owned the property for 18 months. He would now pay long-term capital gains on the profit of $250,000. Jon may also have the opportunity to utilize a 1031 exchange and invest the proceeds of this sale into another like-kind property without paying capital gains tax, thus deferring the taxes to a later date.
(A 1031 exchange is a swap of one real estate investment for another that allows for capital gains to be deferred. There are certain rules and requirements that one must meet to qualify, including owning the property for at least one year, so it is best to discuss this with your tax, financial and legal advisors prior to engaging in this type of transaction.)
By holding the property just a little longer, Jon can save thousands of dollars in capital gains taxes. He also may be able to defer taxes further. As with our young married couple, Jon also needs to consider whether he could still sell for $700,000 if he waits another year or if it makes more sense to sell while the market is hot.
Scenario #5: Advanced Tax Savings Strategy for Sophisticated Investors
James and Keith are a wealthy couple with many different investments in their portfolio. They own several investment properties and would like to sell one that they can get a great price on due to rezoning in the area. They sell the property and make a profit of $500,000. Since these are investment properties, the exclusion does not apply, so they will pay long-term capital gains on the profit.
However, since the stock market is having a rough year, they look at their stock portfolio and notice a large unrealized loss of $400,000 in one of their stocks. They sell the stock, take a long-term loss of $400,000, and reinvest the proceeds into a different stock within the same industry inside their portfolio.
Now, here is where it gets fun. They can use the $400,000 loss to offset the $500,000 gain from the property sale, meaning they have a net capital gain of $100,000! So now they owe long-term capital gains on $100,000 instead of $500,000.
Additional Capital Gains Strategies to Consider
All of this may seem overwhelming, but you don’t have to memorize the details; you simply must know every action must be carefully considered. Don’t underestimate the nuances of capital gains and all the varied possible outcomes. Before parting with a property that has appreciated, it’s imperative to factor in all relevant considerations.
One often underestimated strategy to reduce capital gains is elevating your home’s cost basis through documented home improvements and repairs.
By boosting your recorded costs, you reduce your profit and minimize the capital gains tax liability. Consider Mario and Lisa’s scenario from earlier. Had they diligently tracked receipts for their home’s upkeep and enhancements over the past four decades, they could have augmented their cost basis by a substantial $200,000, significantly mitigating their tax liability upon sale.
Another essential presale exercise, particularly for those in their later years, is contemplating your legacy.
Analyze your asset portfolio to determine what you’ll pass down to your heirs. In the realm of taxation, real estate can be a valuable asset to bequeath. The reason lies in the step-up in cost basis that heirs receive upon inheriting the property.
Again, think of Mario and Lisa. What if they opted not to sell their home, choosing instead to leave it to their children? Upon their death, the home’s fair market value is appraised at $1,500,000. When their children eventually sell it for the same amount, they owe zero capital gains tax because there’s been no profit in their possession ($1,500,000 cost basis – $1,500,000 sale = $0). This is because the children will receive a step up in cost basis when they inherit the home after their parents pass.
Learn the Rules and Play with Caution
Understanding the dynamics of capital gains can be a game-changer. Capital gains tax rules can have a substantial impact on your wealth management. A comprehensive grasp of the intricacies empowers confident and strategic navigation of real estate transactions. Exploring various options, implementing tax savings strategies, and avoiding costly mistakes can make a significant difference.
When it comes to making complex financial decisions, it’s crucial it is to have expert guidance. That’s why we encourage you to seek the insights and support of our experienced financial planners and other qualified professionals like CPAs and tax and estate attorneys. Let us be your compass, guiding you on a successful and informed financial journey. Contact Strata Capital today, and let us help make your complex decisions simple.
Strata Capital is a wealth management firm serving corporate executives, professionals, and entrepreneurs in the New York Tri-State Area, focusing on corporate benefits and executive compensation. Co-founded by David D’Albero and Carmine Coppola, the firm specializes in making the complex simple to ensure clients feel confident in their financial decisions. They can be reached by phone at (212) 367-2855, via email at email@example.com, or by visiting their website at stratacapital.co.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
The information contained above is for illustrative, educational, and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.
Cornerstone Planning Group, Inc., (“CSPG”) is an SEC-registered investment advisory firm. The information contained herein should not be construed as personalized investment advice and should not be considered as a solicitation for investment advisory service. The information (e.g., tax ) provided is believed to be accurate however CSPG does not guarantee or otherwise warrant such information. For more information regarding CSPG you can refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov) and review our Form ADV Brochure and other disclosures.