There are ways you can reduce or sometimes avoid these taxes altogether. Holding onto that investment for a year or more means profits count as long-term capital gains, which are taxed at a lower rate than short-term capital gains. You can also put your money in tax-advantaged retirement plans, or you can offset those capital gains with capital losses.
On the flip side, if you lose money on these, that’s your capital loss—and you can use capital losses to offset any gains for tax purposes.
Now, if you lost more than you made when you sold those properties, you can deduct the difference on your tax return—capped at $3,000.
To determine what tax rate applies to the capital gain, include it in your income. Note that capital gains taxes are progressive.
Let’s say you purchased a home 15 years ago for $100,000 and sold it today for $600,000; you’d make $500,000 on that sale. The entire amount of that $500,000 gain could be excluded from capital gains tax for married couples filing jointly.
However, note that many factors require you to actually pay tax on the whole gain. These include cases when:
- The house wasn’t your main residence
- You didn’t live in the property for at least two years in the five-year period before you sold it
- You already claimed the exclusion on another home
- You bought the house in a 1031 exchange (more on that later)
- You are subject to expatriation tax.
Short-term capital gains are taxed the same way as regular income for tax brackets up to 37 percent. That’s steep compared with long-term capital gains, which are taxed much more favorably at rates that can be as low as zero percent, depending on your income.
For 2020, the capital gains tax rates are either zero percent, 15 percent, or 20 percent for most assets you hang on to for a year or more. Federal tax rates on most assets you hold for less than a year fall into ordinary income tax rates: 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent, or 37 percent.
So investors can put their investment income back into bigger or more desirable real estate, diversify their portfolios, and also restart the timer on the real estate depreciation income tax deduction.
Let’s consider an example of how that works in a real-world real estate investing scenario. Let’s say you bought a starter home five years ago for $200,000 and put $20,000 down. You used it as a rental property for the past three years. Over the course of the time you owned that property, it appreciated to $305,000 in value. If you sold it now and walked away with the profit, you’d owe capital gains taxes of 15 to 20 percent. But instead, you can leverage the tax advantages of the 1031 exchange by reinvesting your money, deferring the tax, and investing the entire profit. You’ll only pay taxes on any portion you didn’t reinvest.
So what constitutes a like-kind property that qualifies for a 1031 exchange? The good news is that term is pretty broad, and most types of real estate are actually considered to be like-kind. So yes, a single-family residence is indeed considered like-kind to a vacant piece of land, a five-unit apartment building, or even a commercial property.
Note that property should be within the United States; a U.S. investment is not considered like-kind to an international one. As well, any property you purchase using a 1031 exchange must be held for investment; you can’t use it for resale or personal use, usually for a minimum of two years after escrow closes.
Let’s say you inherit a home valued at $500,000 on the date of that person’s death. You hold it for a few years and then sell it for $600,000. You would then owe long-term capital gains tax on $100,000.
And you’d owe on that $100,000 figure even if the person who bought the property originally did so for only $250,000. You don’t have to use the original number in your calculation: Instead, your figure is stepped up to the value of the property when the person died. Of course, this typically means your taxable income is much less than it would have been if you were the purchaser at that original $250,000 sale price.
If you do end up selling an inherited home for less than its stepped-up basis, you can deduct that capital loss, as long as you’re not using that property as your own residence. But note that only $3,000 of those losses can be deducted against your ordinary income per year. You have to carry over any excess into future years to be deducted then.
A note here too about 1031 exchanges and inheritance: An investor who continues to reinvest using the 1031 exchange passes that advantage onto heirs. Upon inheritance, those deferred taxes are wiped out. Inherited property that was gotten through a 1031 exchange transfers to the heirs at the stepped-up market-rate value, and at that time all deferred taxes are forgiven.
This 0 percent tax rate on capital gains applies to married couples with taxable income as high as $78,750, and single filers with taxable income up to $39,375.
In normal years, your taxable income might be much higher than that figure—so the strategy wouldn’t apply. But there are some years when you’re in lower income tax situations. Sometimes you can even force this situation, such as after retirement when you can choose which accounts from which to make withdrawals each year. You might also find those tax-free opportunities if you find yourself temporarily unemployed, or if your income varies dramatically from year to year, as with sales commissions, for example.
You might be subject to an additional tax if your income threshold is $200,000 for single or head of household filers, $250,000 for married couples filing jointly, or $125,000 for married couples filing separate tax returns.
Also note that any earnings on your individual retirement account (IRA) won’t get the lower capital gains tax treatment. These are taxed at the same rate as your income.