You likely committed to homeownership because you’ve lived in one city for 2-3 years, actively shored up details about the local rental market, and learned that a profitable rental was possible. Or, by continuously gauging local markets, you determined the locale was affordable and an overall wise choice for a long-term home commitment.
Regardless of the reason for your property purchase, the ultimate sale of the home will have tax implications. Buying a home ignorant of an estimate on these future payments can be a costly mistake. Choose real estate professionals that will not only work on your behalf to find the perfect home and execute a great deal, but who will take the time to explain tax implications and estimate the finances involved with a future sale.
Here’s a look at what you might be in for after the sale of your home.
Tax Implications for Homeowners Selling a Primary Residence
For the majority of Americans, selling a home for profit is a good thing. The government agrees, and fosters the earnings by offering the home sale exclusion, also known as the primary residence exclusion, when it is time to file taxes after selling your primary residence.
With this benefit, joint tax filers are eligible to exclude up to $500,000 in capital gains. Single filers exclude up to $250,000. Beyond these amounts, your profits will be counted as capital gains income and taxed. Keep reading for more information about capital gains.
Here’s the bad news: there are restrictions on these exclusions. But, there’s also good news; military members have their own set of verbage to offset residency rules.
- The house was your primary residence for a minimum of 2 of the preceding 5 years.
- You were the owner for a minimum of two of the preceding 5 years.
- No other home has used the exclusion within a 2 year period before the sale.
These are collectively known as the 2 of 5 years rule, or the use test. It serves to solidify whether or not you’ve lived in the home as a permanent residence.
For military members:
Suspension of time allows for the 2 of 5 year rule to be suspended if a PCS move was ordered for than 50 miles away from the house. This suspension is in effect for no more than 10 years and has a look back period of 15 years. The homeowner cannot suspend more than one property at a time.
As retirement approaches, sort out with a tax professional if there are tax consequences if you decide to sell your home. Suspension of time is a complicated and unclear law when it applies to years near retirement. Consider this analysis part of your transition procedures.
Interested in real estate investment? Start Your Retirement Back Up Plan.
How Capital Gains Taxes Are Calculated
Here is a refresher on what capital gains are. In the simplest terms, when you buy a house and earn more than $250,000 (for singles) or $500,000 (joint filing) on the sale, you have earned capital gains. The federal government taxes a portion of this gains on this income source.
For more detailed information about military and exemptions, read The Effect of Capital Gains Tax Exclusions on Military Home Sellers.
The amount of tax owed is determined by how long the property was owned before selling. Every year, the IRS determines separate capital gains tax rates for long- and short-term asset ownership.
For 2019 and 2020:
- Short term capital gains, for property owned less than one year, the tax is based on your income tax rate, or your tax bracket.
- Long term capital gains tax, for property owned more than one year is 0%,15% or 20% depending on your taxable income and filing status. Long term capital gains rates are typically lower than short term capital gains tax rates.
Single Filers’ Income
- 0% - $0 to $40,000
- 15% - $40,001 to $441,450
- 20% - $441,451 or more
Married Filing Jointly Income
- 0% - $0 to $80,000
- 15% - $80,001 to $496,600
- 20% - $496,601 and more
The IRS has further details for those filing in different categories like head of household and married filing separately.
Cost Basis and Net Sale Price Determines the Amount of Capital Gains
An easy to understand example says a married couple filing jointly who have owned their home 10 years won’t owe any federal taxes on the net proceeds of the home they originally bought for $200,000 unless it sells for more than $700,000.
But for more detail, and to determine how much you will pay in capital gains tax, you’ll need to know how to calculate your cost basis and net sale price. These are the numbers to plug in to determine the amount of capital gains.
- Cost basis. This is the total amount paid to buy the house. This includes acquisition costs (origination fees and the like) and capital improvements (renovations, new appliances).
- Net proceeds. This is the final amount the home sold for after subtracting fees such as real estate agent commissions.
This is a breakdown example from fool.com:
“For example, let's say that you paid $200,000 for your house and sold it for $300,000 a few years later. Sounds like a $100,000 gain. However, if you paid $5,000 in origination fees when you bought and another $20,000 in selling expenses, your capital gains is reduced to $75,000.”
If you’ve sold for a profit, this equation actually diminishes your capital gains and places you in a better position to avoid capital gains taxes.
Tax Implications for Homeowners Selling Rental Property
You’ve decided it's time to sell your rental, either because the allure of landlord life has run its course or financially it doesn't make sense to continue with the investment. Before you hire a real estate agent to put the for sale sign in the yard, educate yourself on what the sale finances actually encompass. Cashing a proceeds check won’t be the only financial transaction; more likely than not, taxes on the sale will occur.
Just like your car, your rental property depreciates every year, meaning you lose value, or some of the worth of the rental. Take note; the structure depreciates, not the land it sits on.
Each year, the IRS offers tax breaks on the depreciation of the home, a benefit for property owners. When the time comes to sell, however, the IRS requires the depreciation benefit returned, otherwise known as depreciation recapture. Or, in other words, if the home sells for more than the depreciated value, you’ll have to pay the taxes you avoided because of depreciation.
Read: 3 Reasons Military Landlords Should Have Their Taxes Professionally Prepared.
The amount of depreciation varies on the value of the rental property and the value of the depreciation is connected to your personal tax bracket which could be at a beneficial 0% if deployments were involved. However, the majority of military families sit in the 10% or 15% nominal tax bracket.
Underestimating depreciation recapture taxes is a common but costly mistake military landlords make, often turning what was thought to be a sure bet investment into a money pit when the sale goes through. It's crucial to carefully conduct a profitability analysis with qualified real estate professionals early into the buying process before purchasing a rental property.
As a real estate investor, your goal is to maximize profit from your rental property. Although typically a strong investment in the long term, your rental won’t always yield money, in fact, you might owe thousands in taxes when it is time to sell. There are some workarounds to alleviate the tax burden, especially if serving as an active duty member.
Turn Your Rental Property into Your Primary Home
Moving into your rental home long enough to meet the capital gains exemption requirements is a possibility, but forecasting a long term stay in one home is a difficult feat to conquer while serving active duty.
These are the requirements to qualify for the exemption.
- Two years of ownership is required for the five-year time frame ending on the date of the sale.
- The property has to be the primary residence for a minimum of two years of five, ending on the date of the sale.
- Exclusion from gains from income cannot be claimed in the previous two years.
The 1031 Exchange
The number 1031 refers to Section 1031 of the Internal Revenue Code. Buyers may also hear, “like kind exchange” in reference to a 1031. What the 1031 allows the homeowner to do is to sell their rental home and reinvest the money into a like kind asset.
Homeowners consider this exchange if they anticipate hefty capital gains taxes, to save on the depreciation recapture, or if a fast transaction is necessary. Under a 1031, the owner does not recognize losses or gains. Capital gains taxes are deferred until the property is sold. A 1031 does not negate taxes, it simply pushes the due date for payment down the road.
A 1031 exchange must also meet this criteria:
- Investment property, commercial property, personal property, and trade property are the only types of property eligible. Personal residences are not.
- Like kind property exchanges have to be the same: real property=real property, not real property=personal property.
- A 45-day time frame is set to identify the exchange.
- The proceeds of the sale are required to be reinvested in like kind property and close within 180 days.
A 1031 exchange is a complicated matter that necessitates a professional intermediaries with years of experience.
Successful home sellers buy their homes with an exit strategy in mind. Without a detailed investigation of what selling options look like in 3, 5, or 10 years down the road, you’ll certainly be taken aback as to how profitable your real estate purchase was in reality. Rental properties in particular have a precise profit and loss equation that has to be solved in order to avoid unknown taxation.
Don't ignore the the limits of your initial real estate investment. Prepare not only for the initial money required to purchase the home, but to also leave the property with as much money in your pocket as possible. This is an important part of homeownership that is often overlooked.
By Dawn M. Smith