Tax Tips For Selling Real Estate

In 1789, Benjamin Franklin stated in a letter to a friend, “… in this world nothing is certain except death and taxes.”

Over 200 years later, both of these observations seem to still hold true. However, with some awareness of the rules and proper planning, taxes can often be minimized, deferred, or even eliminated.

While selling real estate can be a lucrative venture, navigating the complex tax implications is crucial to maximizing your returns. For property owners, understanding the tax implications of a real estate sale is vital for optimizing your financial outcome. In this article, we will explore some key tips to help you minimize your tax liability and make informed decisions before and during a sale of real estate.

Capital Gains Tax

One of the primary considerations when selling real estate is the capital gains tax. Capital gains are the profits made when selling an investment or asset, including real estate. The most important consideration for capital gain income is the holding period of the asset producing the gain. There is a big difference in the tax rates applied to short-term capital gains and long-term capital gains.

Short-term capital gains are gains arising from the sale of an asset that has been held for one year or less. Conversely, long-term capital gains result when the sold asset was held for more than one year.

In order to minimize your tax liability, consider holding on to property for more than one year before selling it. Why? Short-term capital gains are taxed at the sellers regular income tax rates, while long-term capital gains are taxed at more favorable tax rates.

Long-term capital gain tax rates are determined based upon the amount of your taxable income for a given year. The rates are 0%, 15% or 20%, and your rate is determined based upon the amount of your taxable income for the year. A detailed discussion of the capital gain tax calculation rules is beyond the scope of this article, but the majority of taxpayers will pay capital gains tax at the 15% rate. In 2023, for a married couple filing jointly, the 20% capital gain tax rate will not kick in until their taxable income (including the capital gain) exceeds $553,850. Please keep in mind that, depending on your overall taxable income, a portion of your capital gain could be subject to the 0% rate, the 15% rate and the 20% rate.

Your capital gains could also be subject to the 3.8% federal net investment income tax depending upon the level of your income tax. In addition, although generally much lower than the federal tax rates, don’t forget state income tax rates as well.

Quick tip: Consider selling property in a year in which your overall taxable income will be lower so that you can take full advantage of the 0% capital gain tax rate.

Sale of Your Primary Residence

If the property you are selling is your primary residence and you have lived in it for at least two of the past five years, you should be eligible for the Section 121 primary residence gain exclusion. This allows $250,000 of otherwise taxable capital gain to be excluded from being taxed when you sell your primary residence. For a married couple, this exclusion is equal to $500,000.

For a simple example, let’s say you and your spouse bought your home 10 years ago for $200,000 and sold it today for $800,000. For simplicity, let’s also assume that you made no improvements to the home and that there were no closing costs on the sale. In this case, you would have a gain of $600,000, but because of the $500,000 gain exclusion, the taxable long-term capital gain will only be $100,000, greatly reducing the tax burden from selling the home.

There are a few things to keep in mind:

1. Be sure to keep detailed records related to any improvements you make to the residence or property because these improvements will increase your cost basis in the property and lower your gain when it is sold.
2. The 2 year occupancy period does not have to be consecutive. As long as you have lived in the home as your primary residence for 24 months within the last five years prior to the sale, you should qualify for the gain exclusion.
3. The primary residence gain exclusion can literally be used every two years, once you have met the 2-year primary residence occupancy requirements.
4. The gain exclusion does not apply to a second home, only your primary residence, but you can convert a second home into a primary residence by meeting the requirements.
5. There are rules that will allow you to claim a partial gain exclusion if you had to move from your home for a new job, health issues, or other unforeseen events.

Rental or Investment Property

Selling investment properties and rental properties can also produce capital gains, but the rules are a bit different as compared to a primary residence. Of course, there is no primary residence gain exclusion, and there can be another tax rate layer when a depreciable rental property is sold.

If a property has been depreciated for tax purposes, then any gain on the sale of that property equal to the amount of prior depreciation claimed, will be taxed at a 25% federal tax rate. The remaining amount of the gain is subject to the normal capital gain tax rates. This 25% gain is referred to as unrecaptured Section 1250 gain.

There are a number of things that can be done to help you defer or lower your tax liability when you sell an investment property:

1. Consider doing a Section 1031 like-kind exchange. This section of the law allows you to defer capital gains taxes by reinvesting the proceeds from the sale into a like-kind property. Adhering to specific timelines and rules is crucial for a successful 1031, so it is advisable to consult with a qualified tax professional.
2. Sell in a year when you have already taken other capital losses, or if you have loss positions available, consider selling them to help you offset your gain.
3. Consider pulling out your equity by borrowing verses selling the property.
4. Consider using an installment sale, whereby you receive a down payment in the year of sale and remaining principal payments in the following year(s). This could help you manage how much gain you have to report each year.
5. Investment property or a principal residence left to your heirs will receive a step-up in basis equal to the fair market value of the property at the time of your death. This means that upon inheritance, heirs could sell the property immediately and not incur a capital gain.

Final Thoughts

Navigating the intricacies of real estate taxation requires expertise. Engaging the services with a CPA with experience in real estate transactions can provide valuable insight.

Selling real estate involves more than just closing the deal. Understanding the tax implications is essential for optimizing your financial outcome. By considering capital gains tax, leveraging the primary residence exclusion, exploring 1031 exchanges, documenting qualified expenses, and seeking professional guidance, you can navigate the tax landscape with confidence.

If you have any questions or would like additional information, please contact DMJPS CPAs + Advisors.

**Original article published in the Biltmore Forest Reality found here: Real Estate Tax Tips | biltmoreforest.com