The federal capital gains tax on real estate began in 1913. At that point, they were taxed as a form of income, with a maximum rate of 7 percent. In 1921, capital gains were classified separately from traditional income, and the rate increased to 12.5%. Congress has changed the rate over the years. It’s calculated differently depending on the tax bracket of the individual, whether the real estate is an investment property or a primary residence, and when/how the property is sold or transferred. Each state also has its own individual capital gains rate, which varies widely.
To qualify as a primary residence, the piece of real estate must be occupied by the owner for at least 24 months out of a five year period. By living in the property, owners can deduct $250,000 individually and up to $500,000 as a married couple on their taxes if they choose to sell the property. Homeowners that can’t document that they’ve lived in the property for this amount of time, won’t qualify for the deduction. One exception to the rule is if the homeowner experiences “unforeseen circumstances”. Examples would be divorce, legal separation, death, change in employment status, condemnation of the property, or terrorism, to name a few. Owners may choose to rent out their home for the period of time they are not residing in the unit, and still claim the property as a primary residence.
Investment property, on the other hand, has fewer tax exemptions, and a higher tax rate. This tax rate is based on the income bracket of the real estate investor, and marital status. Unlike the primary residence exemption, the owner may not take sizable deductions on an investment property unless it is converted into a main residence. However, if an owner improves the property, depreciation recapture allows an owner to deduct up to 25% of the costs of the improvements from the capital gains tax.
It is possible to reduce, delay, or negate the requirement to pay capital gains tax on both investment properties and primary residences. The 1031 tax deferred exchange (which relates to a section in the IRS tax code) allows an owner to sell his or her property and reinvest the money from the sale into another property without paying any immediate taxes. If a property is passed on as a part of an inheritance, the heirs do not have to pay capital gains on that property.
As always, seek professional advice from a tax accountant and use a Qualified Intermediary when doing a 1031 tax deferred exchange.
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