Capital Gains Tax on Real Estate — PillarWM
In the US, different types of income are subject to different tax rates. For instance, salaries are generally taxed at a higher rate than capital gains on the sale of stocks although stocks are not the only assets that result in capital gains. The profit that you realize upon selling a property is also a type of capital gain, which is taxed differently from gains on sale of stock. Whether you plan to sell your property or run a real estate business, having an understanding of the capital gains tax on real estate is important. While real estate properties aren’t considered liquid assets, if you do hold $5 million to $500 million in liquid assets, reach out to Pillar Wealth Management, which specializes in wealth management services to high net worth individuals. And if your wealth exceeds $10 million, our guide titled 7 Secrets to High Net Worth Investment Management, Estate, Tax, and Financial Planning should prove insightful to you.
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For the time being, let’s take a deep dive into capital gains tax on real estate.
What is Real Estate Capital Gains Tax?
As the phrase suggests, capital gains tax on real estate refers to the tax payable on any gains made from the sale of property. You only realize capital gains when you sell a property for more than what you paid for it. Hence, if you sell a property for less than the purchase price, you won’t make any gains and, thus, won’t have to worry about capital gains tax.
However, it’s quite rare that someone would sell a property for less than what they paid for it. Since real estate typically appreciates in value over time, property owners almost always make capital gains and are liable to pay the associated taxes.
It’s important to understand that regardless of the type of asset you own, you’ll only be liable to pay capital gains tax when you sell it and realize a gain. You won’t owe anything in taxes if the asset you own increases in value, no matter how sharp the increase is. To learn more about capital gains tax on real estate, schedule a video consultation meeting with our wealth managers at your convenience.
Let’s take a look at how capital gains tax applies to different types of property.
Capital Gains Tax on Different Property Types
The profit you earn on the sale of your primary home could be subject to special tax treatment in your favor, no matter how massive the gains are. To qualify for the exclusion, you must have owned the property and have lived in it for at least the two previous years. While the two-year time requirement is an absolute minimum, the aforementioned conditions concerning ownership and residence need not be met in the same two years.
When you do qualify for the primary residence exclusion, you’ll be exempt from capital gains tax on $250,000 of the net profit as an individual taxpayer and $500,000 for a married couple that files jointly.
A second home is a property where you live temporarily, such as during the summer season only, and that is not primarily a rental property, even if you rent it out for a month or two during the summer. Unlike the case of a primary residence, you can own multiple second homes.
Because a second home won’t fulfill the conditions of a primary residence, you don’t get any tax exemption on it. Thus, appropriate short- or long-term tax rates are applicable on any net capital gain you make upon selling your second home.
Investment property is property that is acquired with the intention of earning a return, either through a future sale of the property, through rental income, or both. When selling an investment property, there are two taxes you need to be concerned about. The first is the capital gains tax that applies to the net profit upon selling the property, and the other is depreciation recapture. During the holding period, if you’ve claimed any depreciation expense on your investment property, the total amount you’ve deducted will contribute to your taxable income when you sell the property. The cumulative amount is taxed at your marginal tax rate.
If you manage a real estate investment portfolio, the information above should be useful for tax purposes. But if you possess a portfolio of more liquid investments and wish to grow it, seek inspiration from our free book titled 5 Critical Shifts For Maximizing Portfolio Growth Strategies – For Families Worth $5 Million To $500 Million.
Now that you have a basic idea about how capital gains tax applies to different types of real estate assets, let’s move on to how much you could pay in capital gains tax.
How Much Tax Could You Pay on Real Estate Capital Gains?
To anticipate your tax payments, having an idea of how much capital gains tax is typically paid can be very helpful. Instead of being an umbrella percentage, the tax rate for capital gains depends on various factors that impact the proportion of taxable gain. Four of the main factors are the cost of owning the property, tax filing status, how long the property was owned, and income tax bracket.
Short-term capital gains (associated with assets held for less than a year) are subject to ordinary capital gains tax rates that can be up to 34%, based on the owner’s income level. In contrast, tax rates for long-term capital gains are considerably lower. We’ll go into the details of what the two categories are and what rates apply to them in the upcoming section. To develop a better idea of how much tax do you pay on real estate capital gains, book a video consultation meeting with our wealth managers.
Calculating Your Capital Gains Tax
While an understanding of how much capital gains tax is typically paid should give you an idea of what to expect, to determine how much you’ll actually pay, you’ll need to calculate it. So, this section will answer your next concern: “How do I calculate capital gains on the sale of a property?”
Except for a few intricacies, the formula for calculating capital gains tax for real estate assets works similarly to other assets. The basic formula is as follows:
Capital Gains = Selling Price – Original Purchase Price
While this is the basic formula, let’s go into the details of short-term and long-term capital gains tax.
Calculating Short-Term Capital Gains Tax
As mentioned earlier, one of the factors that impacts your capital gains tax payment is how long the real estate was owned. Your tax payment is determined by whether your real estate investment is short-term or long-term. You’ll be paying short-term capital gains tax on the sale of any property that you sell afterless than a year.
The rate will be the same as the income tax rate for your income bracket. For this reason, short-term capital gains tax rates can be pretty high. Thus, many investors hold onto their real estate and other assets for longer than a year after purchase.
Calculating Long-term Capital Gains Tax
If you sell your real estate asset after holding it for a year or beyond, you will pay long-term capital gains tax on the proceeds from the sale. In 2021, long-term capital gains are subject to a 0%, 15%, or 20% tax, depending on the investor’s filing status and taxable income, excluding any local or state taxes on capital gains.
By now, you should have developed a profound understanding of how capital gains tax is calculated for real estate assets. For a deeper understanding of short- and long-term capital gains tax, schedule a video consultation meeting with our wealth managers.
We’ll now address your next concern: “How do I avoid capital gains tax on property sales?”
How to Avoid Paying Capital Gains Tax on Real Estate
Most investors who focus on liquid assets are aware of how to protect their portfolios, such as by minimizing their tax burden, but few are aware of the top strategies to minimize their capital gains tax on real estate. If you’re a liquid asset investor with at least $25 million in assets and wonder ifyou are paying way too much in taxes, learn how to protect your portfolio by reading our book titled The Art of Protecting Ultra-High Net Worth Portfolios and Estates: Strategies for Families worth $25 Million to $500 Million.
The good news is there are multiple ways to minimize or defer exposure to capital gains tax on a property sale so as to keep a larger proportion of the gains or have immediate cash available. Here are three top strategies we recommend:
Make the Most Out of 1031 Exchange
A 1031 exchange is an investment similar to rental or investment property and is highly popular among real estate investors. When you sell your rental or investment property, the strategy is to reinvest any proceeds from the sale into a 1031 exchange. A 1031 exchange won’t entirely eliminate your capital gains tax, but it will delay the tax payments, freeing up your cash for investing in the replacement property.
While this is an incredible strategy to build wealth, the complex tax code requires you meet multiple criteria to take advantage of a 1031 exchange. If you hold liquid assets, however, and are looking to improve the performance of your liquid investment portfolio, study our Performance guide for help.
Consider Investing in Opportunity Zone Funds
In an effort to encourage investment in infrastructure, housing, and small businesses in certain distressed areas, the US government introduced some tax benefits for property investments made in those areas. These areas are referred to as Opportunity Zones.
If you invest the profits from the sale of real estate into an Opportunity Zone Fund and hold onto them, all capital gains tax will be deferred for eight years.
Investing in an Opportunity Zone Fund provides some tax benefits. If you hold onto the investment for at least ten years, you’ll be fully exempt from paying capital gains tax on the future capital gains from the invested funds. If you hold the investment for five years, the amount you pay in capital gains tax will decrease by 10%.
Hold On To Your Real Estate Asset for More Than a Year
As discussed earlier, when you hold onto a property for more than a year after purchase, long-term capital gains tax will apply, the rates for which are remarkably lower than those for short-term capital gains tax that are based on income tax rates.
While the aforementioned tips may help you defer or reduce your capital gains tax burden, there are many more tactics to save money on taxes. A financial advisor can suggest other tax-saving strategies. To hire an advisor, take guidance from our short book titled Ultimate Guide to Choosing the Best Financial Advisor for Families worth $5 Million to $500 Million.
For many of us, our home is our proudest and biggest purchase. It takes countless online searches, inspections, negotiations, and closing to achieve the status of homeowner. Others may acquire properties as part of their real estate business or for investment purposes. Either way, property is considered a capital asset, so when it’s time to sell a property you own, you’ll likely need to pay capital gains tax on the profits made.
In this guide, you learned what constitutes capital gains tax on real estate, how much is typically paid in capital gains tax, how to calculate the payment, and some effective ways to minimize it. If you need help with managing your liquid assets and associated investments, connect with Pillar Wealth Management, which serves investors holding between $5 million to $500 million in liquid assets. To seek financial advisory services, schedule a video meeting with our wealth managers today!
To be 100% transparent, we published this page to help filter through the mass influx of prospects, who come to us through our website and referrals, to gain only a handful of the right types of new clients who wish to engage us.
We enjoy working with high net worth and ultra-high net worth investors and families who want what we call financial serenity – the feeling that comes when you know your finances and the lifestyle you desire have been secured for life, and that you don’t have to do any of the work to manage and maintain it because you hired a trusted advisor to take care of everything.
You see, our goal is to only accept 17 new clients this year. Clients who have from $5 million to $500 million in liquid investable assets to entrust us with on a 100% fee basis. No commissions and no products for sale.
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