What is a Capital Gains Tax in Real Estate?
Fantastic question! If you’re reading this, you’ve already taken the first step to finding out exactly how much money you could make from selling your property. By now you’ve probably heard all about tax rates, strange fees, and countless other terms that can fog up your vision. Have no fear, we’re going to bust out the biggest spotlight we can find to cut right through that fog and explain what all this means in the simplest terms possible.
Capital Gains Tax Definition
Our good friends over at Webster define Capital Gains Tax as “a tax levied on profit from the sale of property or an investment.”
Important note – there are also several other types of investments that qualify, but for the sake of this article, we are going to stick to Real Estate sales.
For example, if I bought a home for $100,000, and then sold it for $150,000, my profit would be $50,000. In some cases, I would have to pay a Capital Gains Tax on this profit. The percentage of the tax varies from state to state. Here in Georgia, it is taxed the same as normal income. I know, I know… that seems like bad news. But stick with me, it gets WAY better.
How to Avoid Capital Gains Tax in Real Estate
Thanks to the Taxpayer Relief Act of 1997, there’s now a wildly beneficial and completely legal way to avoid paying taxes on the profit from your real estate sale. If the property you sell was your primary residence for 2 of the previous 5 years, you are eligible for exemption of the capital gains tax on your profit!
Rules for Capital Gains Tax Exemption
Aww, come on, you didn’t think it was quite that easy did you? Well, it really is! However, there are a few stipulations and limits in place to make sure the Relief Act isn’t exploited. Think of these as safeguards to make sure this program can stick around.
- Like I mentioned above, you MUST have lived in the home for at least 2 of the previous 5 years. Yes, that means that you are not eligible for exemption if you have owned the property for less than two years. Good news though, the years do not have to be consecutive!
- Exemptions are limited to $250,000 if you file your taxes as single and $500,000 if you file jointly as a married couple. For example, if you are filing as single and bought a home for $500,000, and after living in it for 2 years, decided to sell it for $800,000, only the $250,000 of profit is exempt. You will pay capital gains tax on the additional $50,000. (note: you can stack the cost of value-adding changes to the property on top of the $250,000, but best ask your accountant or tax advisor for more detail about this.)
- This capital gains tax exemption is only available to use once every two years. Pretty simple rule here. If you sell a home on January 10th, 2022, the next sale that would be eligible for this exemption would have to be on or after January 11th, 2024.
Capital Gains Tax Examples
- Bob buys a home for $100,000. He lives in it for exactly 2 years before selling it for $150,000. Bob has made $50,000 of tax-free profit.
- Susan buys a home for $200,000. She lives in the home for 1 year, then moves away and rents it out to her friend for 3 years. Then, she moves back and lives in the home for another year, before selling it for $300,000. Susan has made $100,000 of tax-free profit. Even though her years of residence weren’t consecutive, she did live in the home for 2 of the previous 5 years at the time of the sale.
- George and Anastasia buy a home for $500,000. They live in the home for 10 years and then sell it for 1.2 million dollars. George and Anastasia have just made a tax-free profit of $500,000, but do have to pay a capital gains tax on the additional $200,000 of profit, since they hit their limit.
- Lastly, a tricky one. Malachi buys House A for $200,000 and after living there for 2 full years, buys House B for $300,000 and lives there for 2 years while renting House A to a friend. After the 4 years, he decides to sell both homes. House A sells for $250,000 and House B sells for $375,000. Since Malachi can only file for the exemption once every two years, he would be best served by doing so on House B, since it has more profit. He would end up with $75,000 of tax free profit from House B, but would be required to pay Capital Gains taxes on the $50,000 profit from House A.
To keep reading and to check out how your state measures the Capital Gains Tax percentages, check out these sources below!