Price increases in today’s market have made capital gains tax a hot topic. As a real estate agent, having a solid understanding of how these taxes work and, more importantly, how to avoid paying capital gains tax on real estate sales, can help you provide better service for your clients. It will also increase the value you can offer them in a competitive market.
Let’s explore what you should know about real estate capital gains tax.
What is the Capital Gains Tax on Real Estate Sale?
The capital gains tax is the tax that people pay on the profit of an investment when they later sell it. The tax specifically taxes the difference between the purchase price and the selling price of the property. For example, say that someone purchases an investment property for $300,000 dollars and then decides to sell it five years later for $400,000. In this situation, the real estate capital gains tax will specifically look at that $100,000 difference.
Capital gains taxes look at two types of investments: long-term and short-term investments. Long-term investments are described as those owned for more than one year, while short-term investments are owned for less than one year. These two different categories also have two different tax rates.
When trying to figure out exactly what would be owed on real estate capital gains tax, it is important to note that several different factors will impact the final rate. These include:
- The income and the tax bracket of the seller;
- The person’s marital status;
- How long the home (or other investment) was owned;
- Whether the home is considered a primary residence, rental property, investment property, or other type of property.
With these different factors, it is important for each person to carefully take their own circumstances into account as they try to figure out the tax rate they will owe.
How To Avoid Capital Gains Tax?
When people realize that they now have to worry about a capital gains tax, they typically want to find ways to minimize how much they will owe. Fortunately, there are several strategies that can help them minimize the tax burden, or at least defer it some. Here are some of the most popular and successful strategies.
Using Tax-Deferred Funds
When a person sells a home, they do not have to place the funds immediately in a typical bank account. Instead, they can use accounts such as IRAs or a 401(k). With these types of accounts, the money can grow tax-free. Additionally, IRA contributions can help the client potentially gain even more tax deductions.
Use the Primary Residence Factor
The IRS does not charge capital gain taxes on the sale of primary residences for profits of up to $500,000 for married couples and $250,000 for single filers. This presents a tremendous opportunity for homeowners to avoid capital gains taxes when they sell properties. However, people do have to meet certain criteria to list a home as a primary residence. Specifically, they have to own and live in the home for at least two of the last five years. Additionally, the owner cannot have used the primary residence exemption on the sale of a different property in the past two years.
Use Tax-Loss Harvesting
With tax harvesting, a person deliberately sells one investment at a loss to offset the profits made from another asset. For example, if someone knows they will have a lot of profit from the sale of a home, they might sell a different property for less than they paid for it to offset the overall capital gains.
Employ the 1031 Exchange
Typically, the IRS will charge people taxes on the value of the depreciation amount they received for the property. However, the 1031 Exchange can help property owners navigate and avoid this situation by using the income from the sale of one property to buy another property of equal or greater value.
Deducting Depreciation
The IRS also allows property owners to deduct the annual depreciation of rental properties they own. The lifespan of a given property is estimated to be 27.5 years. This can then be used to determine how much should be deducted each year.
Deducting Property Management Costs
Property owners with rental properties also know that the costs associated with managing the property can quickly add up. Fortunately, these costs can be deducted. For example, a property owner might deduct the cost of business equipment, travel costs associated with managing the property, and repair costs. To properly make these deductions, you want to make sure you keep impeccable records and receipts of what you spent on the home.
Improve the Property
Improving your property can also give owners a means of building the value of their home while also increasing deductions. Types of improvements that can be used for this strategy include things like replacing windows, updating the HVAC system, or updating appliances. Owners can also include the costs associated with appraisals.
Why Should Agents Understand Taxes on Selling a House?
As a real estate agent, you will likely have clients trying to navigate the complexities of real estate capital gains tax and how it will impact the sale of their home. The more insight you have into how this tax works, the more capable you will be of providing stellar service to your clients.
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