Capital Gains on Real Estate. February 2021 Update.
A full PDF of this post can be found here: CAPITALGAINSUPDATE
I came across a good article about Capital Gains Taxes on Realtor.com It was written by Margaret Heidenry. The full article can be found here:
So basically I want to share with you what the article says and comment on it. But first a full disclosure that I am not a tax advisor, I am not an accountant, and I am not an attorney. So these comments are just my opinion and you should not take them as financial advise, accounting advise or legal advise. For that, please consult with your accountant or attorney. I am a licensed real estate broker associate and as such, we must be familiar with the changes in the capital gains taxes and that is why I wanted to make you aware of this update.
To give full credit to Mrs. Heidenry, I have left her words in between quotations. I have also consulted with CPA Jonathan Sundack from www.SundackCPA.com who answered some of my questions below. Thanks to him for his valuable advise.
“Capital gains tax is the income tax you pay on gains from selling capital assets—including real estate. So if you have sold or are selling a house, what does this mean for you? If you sell your home for more than what you paid for it, that’s good news. The downside, however, is that you probably have a capital gain. And you may have to pay taxes on your capital gain in the form of capital gains tax.” The way I understand this is that Capital Gains are only an issue when you have a profit; in other words, it is a good problem to have, because if you lose money on a real estate deal, most likely, you won´t have to worry about capital gains.
“Complicating matters is the Tax Cuts and Jobs Act, which took effect in 2018 and changed the rules somewhat. Here’s what you need to know about all things capital gains.” This is the update I was referring too and that affects the capital gains taxes at the federal level. Important to know. Again, this is for Uncle Sam. Not for your particular state. According to Mr. Sundack, in NYS , Capital Gains taxes are taxed as regular income. This is a big difference.
“capital gains tax is a tax levied on possessions and property—including your home—that you sell for a profit.”
“If you sell it in one year or less, you have a short-term capital gain. If you sell the home after you hold it for longer than one year, you have a long-term capital gain. Unlike short-term gains, long-term gains are subject to preferential capital gains tax rates.” What this tells me as a Real Estate Agent, is that the time you list, sell and close a property may make a difference in my seller client capital gains exposure. In my experience, real estate investors know this well, regular homeowners, may not be as aware.
Primary Residence Exemption.
According to CPA Jonathan Sundack, the IRS will give a $250,000 exemption (or an amount to be excluded from capital gains taxes) to a single filer who meets certain criteria and a $500,000 capital gains tax exemption to a married couple filing jointly, provided they meet certain criteria. To me, as a homeowner this is great because the tax benefits of real estate gives it an advantage over other types of investments. Understood that your primary residence is not considered investment real estate for the IRS in the context of capital gains taxes. But for the lay person that is thinking to buy (invest) their first home or their primary residence, vs. renting and investing the money in the stock market, you may say that the money invested in your primary residence has many advantages over other investments. If I sell stock at a gain, I don´t have this $250,000 exemption. So your first home, which for many Americans is the biggest investment of their lifetimes and the most important one, comes this exemption not given to other types of investments.
Even when you consider rental property, which does not allow this capital gains exemption of $250,000/$500,000, and you compare it to investing in the stock market, rental property enjoys depreciation and deductions the stocks do not. I guess this is a good way to compensate you for the management and dealing with the tenants.
Ms. Heidenry gives us a good simple example:
“So if you and your spouse buy your home for $100,000, and years later sell for up to $600,000, you won’t owe any capital gains tax, says New York attorney Anthony S. Park. However, you do have to meet specific requirements to claim this capital gains exemption:
- The home must be your primary residence.
- You must have owned it for at least two years.
- You must have lived in it for at least two of the past five years.
- You cannot have taken this exclusion in the past two years.”
Basically, your vacation home or pure investment property would not qualify for this exemption. As CPA Sundack confirmed, a two family where you live and rent the other unit, would be treated as two separate entities for this purpose, one half of it would be treated as your personal residence and one half of it as an investment. You can reach out to him for more details: Jon@Sundackcpa.com . He also said that the 2 years you must have lived in do not need to be consecutive years, meaning, you must have lived in the property any 2 years out of the last 5.
The article goes on to say:
“If you don’t meet all of these requirements, you may be able to take a partial exclusion for capital gains tax if you meet certain exceptions (e.g., if your job forces you to move before you live in the home two years). For more information, consult a tax adviser or IRS Publication 523.”
About the Capital Gains Tax Rates
“For capital gains over that $250,000-per-person exemption, (or $500,000 for married couples/joint filers) just how much tax will Uncle Sam take out of your long- term real estate sale? Long-term capital gains tax rates are based on your income (pre-2018 it was based on tax brackets), explains Park.” This is a big difference and the 2018 act may proof to be a windfall to a lot of tax payers.
Your tax rate is 0% on long-term capital gains if you’re a single filer earning less than $40,000, married filing jointly earning less than $80,000, or head of household earning less than $53,600.
Your tax rate is 15% on long-term capital gains if you’re a single filer earning between $40,000 and $441,500, married filing jointly earning between $80,001 and $486,600, or head of household earning between $53,601 and $469,050.
Your tax rate is 20% on long-term capital gains if you’re a single filer, married filing jointly, or head of household earning more than $496,600. For those earning above $496,600, the rate tops out at 20%, says Park.
Don’t forget, your state may have its own tax on income from capital gains. And very high-income taxpayers may pay a higher effective tax rate because of an additional 38% net investment income .”
So, the most astounding change I notice is that 0% Capital Gains Taxes at the Federal Level for single files making less than $40,000 or joint filers making less than $80,000. I know a lot of clients, many of them first time home buyers who bought their property in affordable areas who may benefit from this. For example, if you guys bought a 1 family house in Elmhurst in the year 1995 , you may have paid $200,000 for it. This property may be worth now $1,200,000, for argument´s sake, because the zoning is R6 and it is a buildable lot, very sought after by developers.. Granted that there is the big $500,000 exemption and also capital improvements (I will talk about this below) that increase your cost. But if there is a profit in excess of the exemption and the capital improvements, you would be paying 0% capital gains at the federal level.
Stepped Up Basis when you inherit a property
The article talks about what happens when you inherit a property:
“What if you’re selling a home you’ve inherited from family members who’ve died? The IRS also gives a “free step-up in basis” when you inherit a family house. But what does that mean?
Let’s say Mom and Dad bought the family home years ago for $100,000, and it’s worth $1 million when it’s left to you. When you sell, your purchase price (or “basis”) is not the $100,000 your folks paid, but instead the $1 million it’s worth on the last parent’s date of death.
You pay capital gains tax only on the difference between what you sell the house for, and the amount it was worth when your last parent died.”
As a real estate broker I am aware of this because I get calls from clients who wanted to know the value of their newly inherited property as of the date their parents passed away, because their accountant needs this information. As a broker, I can go back for years and determine the value of the property with a high degree of confidence and with supporting documentation (comparable sales as of that date in the past) accountants will be satisfied with the evaluation provided by an experience broker. We do this as a free service to any client who needs it.
Adjusted cost basis
The Realtor.com article talks about this concept. I wanted a little bit more specifics and so I asked Mr. Sundack, the CPA to elaborate. When you calculate the cost of your primary residence to determine the capital gains taxes, you can add to that cost the capital improvement made over the years. So If you paid $200,000 for a property and spent $200,000 in improvements (not repairs or maintenance), then your cost, or adjusted cost basis is $400,000. This is why it is so important to keep receipts for all the improvement you make to your home. I pressed him further about this and asked him what the IRS considers improvement which you can add up to increase your cost basis. Here is his response:
“Improvements are expenditures that add to the value of the house, prolong the useful life or adapt it to new uses.
Examples of Improvements That Increase Basis:
Central air conditioning
Air/water filtration systems
Lawn sprinkler system
Lawn & Grounds
Soft water system
Pipes and duct work
Also don’t forget actual closing costs (not prepaids, insurance, etc.) on purchase and sale count as part of basis.”
Pay close attention to this last sentence because I find that many people don´t know it. It explains that you can actual increase your cost basis by taking into account closing costs (not prepaid expenses such as insurance) when you purchased the property. Similarly, your closing expenses when you sell your property (attorney´s fees, transfer fees, broker´s fees) increase your cost basis. I could tell you that these closing expenses are tax deductible, but I won´t because that is not the way you are supposed to understand it. They increase your cost basis, therefore reducing your capital gains taxes by the same amount.
Finally, the article talks about how to avoid paying capital gains taxes on investment property through a financial operation called a “1031 like kind exchange”. This part of the article I thought it was a little too simplistic because this subject requires a lot of explaining and understanding of financial concepts. First of all, it is not that you avoid paying taxes, it is rather that you defer them by investing in another property meeting certain many stringent conditions. Because I wanted to focus more on the situation of homeowners who are thinking of selling their primary residence, we will leave this subject for another time