If you own a home or other real estate in Lake Forest, Illinois, it can feel great to know that your property has risen in value. However, if you decide to sell your property, the IRS may take a bite out of your earnings. That’s because capital gains on real estate sales can be subject to tax. Then again, whether you’re planning to sell your home or investment property, there are tax deductions and exclusions that you can use to maximize your profit. Check out this helpful guide to learn how to avoid capital gains tax on real estate.
Understanding Capital Gains Tax on Real Estate
To effectively lower tax on capital gains from property sale, you should have at least a basic understanding of how this type of tax works. This can help you become familiar with terms and concepts related to capital gains tax.
Definition and Overview of Capital Gains Tax
In the real estate context, capital gains represent the appreciation in the value of a property from the time it was bought or acquired. Basically, they refer to the increase in the property’s purchase price. If you sell your property for a higher price than what you bought it for, you may have to pay capital gains tax on the profit you make from the sale.
How does capital gains tax work on real estate? Similar to income tax, capital gains tax on property sale is progressive, meaning your tax rate rises as your income increases.
Another factor that affects your capital gains tax on real estate is the amount of time you owned the property you sold. A long-term capital gain is the earnings from a property sold after more than one year of ownership. In this case, your tax rate will be based on your taxable income. Profit from the sale of a property held for up to one year is a short-term gain, which is subject to the same rate as your ordinary income. Typically, taxes on long-term gains are more forgiving, with many people qualifying for a 0% tax rate.
Calculating Capital Gains on Real Estate
As mentioned earlier, a capital gain is the net profit from the sale of a property. It’s calculated by subtracting the cost basis of your property from its selling price. Your cost basis is the total amount you paid for your home, including the purchase price, expenses related to the purchase, home improvement costs, and legal fees. Depending on circumstances, it can rise or drop over time.
Example Calculation of Capital Gains
Let’s look at an example of how capital gains from property sale is calculated. Suppose you purchased your Lake Forest home for $350,000. Over the 10 years you lived there, you didn’t make any improvements or incurred any losses. Then, you decide to sell your home for $450,000. Your cost basis is $350,000, and your taxable capital gain from the sale is $100,000.
Strategies to Minimize or Avoid Capital Gains Tax on Real Estate
Capital gains tax on property sale can cost you thousands of dollars. Fortunately, you can take certain measures to reduce or avoid capital gains tax on real estate, such as:
Utilizing the Home Sale Exclusion
There are exceptions to capital gains rules on selling a home that can be effective ways to avoid paying capital gains tax. One of these is passing the “ownership and use” test. You’re only eligible for this test if you’re selling your principal or primary residence, which is the home where you’ve lived for the majority of the tax year. Additionally, you must have lived there for a minimum of two years over a five-year period prior to selling it. However, these two years don’t have to be consecutive.
If your capital gain doesn’t exceed the exclusion threshold, you don’t owe any taxes on the sale of your home. The threshold is $250,000 for single filers or $500,000 for joint filers.
Employing Like-Kind Exchanges (IRC Section 1031)
Another way to reduce capital gains tax on real estate is to engage in a like-kind exchange, which is also known as IRC Section 1031. Such a transaction involves selling a property and purchasing another one of similar value. This enables you to hold your taxable gain for more than a year. Eventually, the profit from your property sale will become a long-term capital gain, which qualifies you for a better tax rate.
Converting Second Homes Into Primary Residences
To qualify for the exclusion on capital gains tax on primary residence, you can convert your second home or investment property into your primary residence. You can strengthen a property’s status as your primary residence by using its address in your official documents, such as driver’s license, tax returns, and voting registration. Also, the residence should be within the proximity of your workplace, bank, and other amenities you need.
Timing the Sale for Tax Advantages
Spreading your earnings from the sale of your property across multiple tax years can help you stay within your current income tax bracket or even drop to a lower one. Try to get the buyer to agree to purchase the property with multiple payments rather than a lump sum. Nonetheless, bear in mind that you must receive one or more payments following the tax year in which the sale occurred. When you file your taxes, report your capital gain under “installment method” on IRS Form 6252.
Need Professional Help? Consult a Tax Expert in Lake Forest Today
While it can be done, reducing or avoiding capital gains tax on real estate sales can be a complicated and overwhelming task. If you’re planning to sell your home or investment property in the Greater Chicago area, consider getting in touch with the tax experts at Pasquesi Sheppard. With extensive experience in the real estate industry, we can help you navigate capital gains taxes, devise strategies that suit your situation, and get the most out of your property sale. Contact us today to schedule a consultation.
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