Capital Gains Rules for Real Estate

Anytime a person acquires a real estate property asset and then later sells it for any sort of profit, it becomes a capital gain. In the U.S. capital gains are taxed by the IRS. As such, it is to your benefit to fully understand capital gains tax laws with regards to real estate property. This may help you reduce your tax liability on such transactions.

Short-term vs. Long-term

Real estate can be taxed as a short-term capital gain, but it can also be considered long-term or ordinary gain. It depends on how the property will be used by the owner or taxpayer.

For short-term capital gains, the rate can vary, but usually remains within the 10 to 35% range. For long-term gains, things are different. Assets owned for more than one year will generally be taxed under a different rate, while other long-term assets will have a rate applied that is dependent upon which ordinary income tax bracket the taxpayer falls under.

It is possible to qualify for a zero percent rate if one’s income, including the capital gains, falls in the 10 or 15% brackets. Properties will be charged at a 15% rate for those who have a total income that falls under the 25% or higher brackets.

Capital Gains for Rental Properties

A property that is being rented will be taxed as a combination capital gain, but will also fall under depreciation recapture tax rates. This means that the government is considering that the property is a profitable venture, but is also factoring in the fact that buildings tend to depreciate in value over time when calculating taxes.

Determining the actual gain or loss someone incurs from the sale of such a property requires several details. The selling price, the adjusted basis, subsequent improvements made to the property, and the depreciation are all factors in the computation. Note that depreciation recapture rates are applied to the full amount, while capital gains tax rates are usually applied to what is left after depreciation is factored in.

Capital Gains Tax on the Sale of a Home

Profits made off real estate used as someone’s primary residence can qualify for some forms of special capital gains exclusions. Single owners can exclude up to $250,000 from the profits of the sale, while married couples can exclude up to $500,000.

To qualify as “primary residence”, however, the property must follow these rules:

– In the five years prior to the sale of the property, however, the owner must have lived in the house for a minimum of 24 months

– The 24 months out of the five-year period need not be consecutive

– Property mortgage rates have no bearing on qualification

Possible exclusions may apply for those who have lived on the property for less than 24 months. Exceptions can be considered if the house was sold because the taxpayer had to move because of work, or some similar unforeseen circumstance.

If the property is a second home or is otherwise not acting as the primary residence, it will be treated either as a short- or long-term capital gain, based on how long the house has been the property of the current owner.

 

Offsetting Taxes From Capital Gains

Capital gains are good, for most people. This is what happens when a property or asset is sold at a higher value than when it was purchased, resulting in a profit for the previous owner. Among the most common types of property to have this would be real estate, but it can also apply to stocks and bonds. However, the issue of capital gains tax mars the process somewhat. These are taxes applied to the sale of such properties and gains, both short-term and long-term. Short-term gains are at the same rate as regular income taxes, while long-term transactions have a much lower rate. For many investors and buyers, the capital gains tax can represent a large amount of money lost from the transaction, so they seek ways to avoid it.

For those that are dealing with property in the transactions, among the most common ways is to use the Section 1031 exchange, if the properties qualify. This involves the exchange, rather than sale, of real estate properties used for the purposes of investment or business. The properties in question must be of like kind, but not necessarily of the same grade or quality. Both must also be used for purposes or functions that further the business or investment. If both properties involved meet the requirements of the regulation, then it is possible for the exchange to push through exempted from all capital gains tax.

Long-term investments are also suggested. The idea for this is to invest in a company for a long period before selling, to get the lowest rate of the capital gains tax. However, this is usually difficult to achieve because of a number of factors. The status of the company can change, drastically affecting the value of their shares. There are any number of valid reasons that may make someone sell earlier than expected, thus paying a higher capital gains tax.

Finally, the most drastic option is to use capital losses to offset the gains. This strategy requires that investments actually decrease in value, which allows one to also decrease the amount of tax paid on them. Ideally, all investments should be appreciating, but losses can occur and it is good to know that these can be used to offset other gains. However, it is still ill-advised to depend on this entirely, both because of the depreciating investments and the existence of a cap on the amount of losses that can be used to offset gains.

Avoiding Capital Gains Tax On Real Estate

Real estate investments have been rising over the last five years, with investors becoming attracted to their value but also preferring to avoid the increasing problems that come with real estate specific taxes. Capital gains tax is among them. With corporate stocks, it is possible to sell the shares over a period to spread out the tax on the gains, but this is not applicable to real estate properties – the entire amount must be claimed on the taxes in the year the property was sold. One of the most prominent ways to avoid capital gains tax on the sale of real estate is the Internal Revenue Code Section 1031 exchange.

One of the main downsides of a real estate investment is that they are not liquid assets. It can take a year or more to settle a deal and selling it while the value is high can result in a significantly larger tax value than the potential profit. The easiest way to mitigate this problem is to control the year in which the title and formal possession of the property. This allows people to set the year of the transfer of ownership to one which is more likely to have a lower tax burden. This does not completely mitigate the capital gains tax, but the right timing can significantly reduce the amount that needs to be paid. However, if paying a large tax on the gains seems inevitable, a 1031 exchange is still a valid option.

The 1031 exchange allows investors to trade real estate held for the purpose of investment for other investment real estate and incur no immediate tax liabilities. Under Section 2031, those who exchange property used for investment or business purposes solely for business or investment property of a similar kind will not be subjected to capital gains tax, as there is no legally recognized gain or loss until the new property is sold. Note, however, that Section 1031 is limited and does not apply to the exchange of inventories, stocks, bonds, notes, evidence of indebtedness and other types of assets.

There are certain conditions that must be met to achieve a full tax-free exchange under the rules of Section 1031. The properties must first be of “like kind” – this means that they must be of the same nature or purpose, even if there is a difference in grade or quality. The properties must also be related to business or investment, and must be held or used for the production or purpose of such. The properties must also be traded for the same use.
The time interval for the transfers is also limited. The property that is to be received must be identified within 45 days of the first transfer. This must be identified in writing during the given 45-day window. The transfer itself must be received within the 180-day period following the property transfer or by the tax return due date for the year in which it was to be transferred, depending on which comes sooner.

Note that there are certain restrictions on the applications of a Section 1031 exchange. It does not cover exchanges between property in the US with one from another country. Property involving personal purposes, such as rental property or a personal residence, will not be included under the limitations of a 1031 exchange.

Primer: Capital Gains Tax

A capital gains tax is a tax charged on capital gains – profits from the sale of a non-inventory asset that was purchased at a lower price. This is commonly placed on the sale of company stocks and bonds, as well as precious metals and real estate properties. US tax regulations divide this into short-term and long-term gains. Short-term refers to capital owned for one year or less, while long-term is includes capital owned for more than one year but less than five years prior to their sale.

Within the US, both individuals and corporations pay income tax on the net total of all capital gains just as they would for any other income, but with a lower rate for long-term capital gains. The tax rate on such gains was reduced to 5% from the original 15% in 2003 for those who belong to the two lowest income brackets. Short-term capital gains fall under the ordinary income tax rate.

Provisions on Section 2011 of the Small Business Jobs Act of 2010 allows for an exemption of 100% of taxes on capital gains for angel and venture capital investors in small business investments if held for a period of five years. The temporary exclusion of capital gains tax was part of the Tax Relief, Unemployment Insurance Re-authorization, and Job Creation Act of 2010 as part of an economic stimulus. The new 2011 budget is set to propose making the elimination of the capital gains tax on key investments in small businesses permanent, and has been passed as a temporary provision in the Small Business Jobs Act of 2010.

It has been noted that the capital gain which the tax is calculated on has not been adjusted for currency inflation. This result in scenarios where the gain is entirely due to inflation and is, therefore, not a gain at all. Nevertheless, the illusory gain in these circumstances is still taxed. Similarly, situations where the property’s value does not keep pace due to inflation will find themselves taxed as gains when they actually result in a loss.

In general, investing in companies and holding that investment in the long-term will result in the lowest rate of capital gains tax. However, this is highly simplistic and does not factor in potential changes, such as the value of the company and economic shifts.

The IRS allows for individuals to defer their capital gains tax with strategies such as the structured sale, charitable trust, installment sale, private annuity trust and a 1031 exchange. Note that US citizens are subject to paying US taxes on their income, regardless of where they reside, as per current tax regulations.