Real estate has increased in popularity as a private investment. This is partly because of the capital gains income tax advantage it offers over other investment classes.
With stocks and bonds, all long term gains are now taxed at 15 percent by the IRS. (That could change and increase after a new US President takes office in January 2009).
With the sale of principal residence (your home), individual sellers can exclude the first $250,000 in profit from income tax. Married couples filing jointly can exclude $500,000.
To qualify, a taxpayer must have owned the house for at least two years and used it as principal residence for two out of five years before the time it was sold. The two years do not need to be consecutive.
When a taxpayer owns more than one residential property, determining whether a house qualifies as a principal residence requires looking at how the property is used, and other circumstances, such as owners' place of employment and where they receive their bills.
A taxpayer could in theory sell a principal residence one every two years, each time walking away with a income tax-free gain.
There are strategies for sellers to use to mitigate or reduce income tax liabliity.
The capital gain on sale of a home is defined as the amount realized on the sale minus the cost basis. The amount realized is the sale price minus selling costs.
Selling costs include real estate commissions, legal fees, title and escrow fees, advertising, money spent to fixe up the property just before sale, loan charges paid by seller (such as loan placement fees or points), and real estate excise taxes.
To calculate cost basis:
1. Start with purchase price paid for the home.
2. Add these adjustments:
A. Costs associated with original purchase of the property.
B. Costs associated with major improvements to the property.
Major improvement are those that add to the value of your home, prolong its useful life, or adapt it to new usess. Finishing an unfinished basement, putting in new plumbing or wiring, or putting on a new roof would qaualify. An addition, such as a deck, runroom, or garage, is also an improvement. This category doesn't include the cost of route maintenance or repairs, which are not associated with major improvements.
3. Subtract decreases, which as:
A. Gain postponed from sale of a previous home (before May 7, 1997).
B. Deductible casualty losses, such as those caused by natural disasters.
C. Depreciation allowed or allowable if the home was used for business or rental purposes.
The resulting amount is the adjusted costs basis. Subtract the adjusted cost basis from the adjusted selling price (selling price minus selling expenses) to arrive at total capital gains.
Homeowners should keep careful records to prove a home's adjusted cost basis for tax purposes. Information to keep could include proof of purchase price and purcahase expenses, receipts for improvements that affect the home's basis, and any work sheets used to calculate the adjusted basis of a prior home that was sold.
Exceptions: Under certain circumstances, taxpayers may qualify for a hardship exception to help them lower their capital gains taxes, even if they have not met the two year time requirement. Under certain conditions, hardship includes a change of employment, health problems, and military services (see Internal Revenue Code). Military personnel who are required to live in government quarters or who are stationed at least 50 miles from their primary residence may have up to 10 years to mee the two year residence requirement. The hardship exception also applies to unforeseen circumstances, such as natural disasters and acts of war.
Conclusion: The favorable treatment of capital gains for income tax purposes can be a good reason to invest in real estate. It can also be a motivation to sell a primary residence and move on before the amount of gain exceeds the amount of allowable deduction.
Warning: People should always seek the advice of a income tax adviser before making any tax related decisions about their home.
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New Twist from U.S. Housing and Economic Recovery Act of 2008:
- Increased funding for Fannie Mae and Freddie Mac.
- Expanded loan limits in high cost areas.
- Tax credit of $7,500 for first time home buyers (Haven’t owned a home in 3 years) - more on this later.
In this large legislation, it’s easy for things to be missed. Here is an example.
New Rules - targeted at the savvy investors who were buying a property, living in it for two years, then moving on to the next property and keeping the old one as a rental.
New Formula -
The new rule takes into consideration the actual usage as a primary residence over it’s qualified life.
An Example -
You bought a home for $200,000 five years ago. You moved out of it three years ago so you could buy your new home. You’re now selling the home you bought 5 years ago for $225,000. Your profit is $25,000.is $25,000.
Old Law:
- You have no capital gains tax liability on this profit. It didn’t matter if you moved away from that property after two years and turned it into an investment property.
New Law:
- Since you lived in the home 40% of the time, you’ll be responsible for capital gains on $15,000 of that profit. That's a change.
Result:
That’s $0 considered capital gain vs. $15,000. Big change. This could cost a lot of investors some serious cash.
What Do You Do?
This new rule doesn’t mean that it’s no longer a good idea to buy a home and move every two years. If you are planning on buying a home every two years, when you sell it you’re tax liability just increased.
When Does This Become Effective?
You will have until January 1st, 2009 until this comes into play.
If you are in this category of investor, you should take action and implement a strategy that works for you.
A real estate professional and tax professional can help you determine if now is the right time.
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Harrison & Christi Long
Realtors & Advisors
Explore Group, Coldwell Banker Previews
949-854-7747
Explore Real Estate
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The information set forth here is not the providing of legal services or services of an accountant. If a person wants or needs such professional services, he or she must contact and retain counsel or a qualified accountant. There are risks associated with the acquisition and ownership of real estate.
Lowering Capital Gains & Income Tax Liability
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