Facebook
Twitter
Pinterest
Copy Link
HOME OFFICE? VACATION HOME? KNOW HOW CAPITAL GAINS CAN IMPACT YOU!
The residential real estate market is still frothy, so in all likelihood your property (or properties) has gone up in value since it was purchased. Knowing what tax consequences you’ll be facing before disposing of the property can greatly help you plan your financial future.
TLDR – Skip to the sections that are relevant to you.
Below, I’ll be covering 6 common property ownership types and some basic guidelines that owners and investors should know.
- Primary Home
- Primary Home w/ Home Office Deductions
- Vacation Home
- Vacation Home converted to Primary Home
- Rental Home
- Like-Kind Exchange (1031)
1. Selling your Primary Home
The capital gains tax exemption for selling your primary home is the most well-know. If you’ve owned and lived in your main home for at least two out of the five years before selling, then up to $250,000 (or $500,000 for join filers) of your gain is tax-free. Anything above this threshold is taxed at capital gains rates (15 or 20%).
To figure out your tax basis, start with the initial cost, add settlement fees, closing costs, plus the cost of additions or improvements that add to the value of your home. Talk to your CPA or refer to IRS 523 about which expenses fall into improvements or either into repairs (repairs are not tax-deductible). In case you, or someone you know, plan to sell before two years, a proration of the exclusion might be applicable depending on the circumstances. Example: job changes, illness or unforeseen circumstances. This is calculated as a percentage (example: having lived in a house for 15 months prior to sale equals 15/24. Multiply this by your exclusion limit ($250,000/$500,000). 15/24 * $250,000 = $156,000 or 15/24 * $500,000 = $312,000.
2. Selling a Primary Home w/ Home Office Deductions
In the wake of the “work from home” trend, you, or someone you know, might be wondering what the tax consequences are if the “home office deduction” has been taken. This is where a room or other space in the residence has been exclusively and regularly has been used for business or rental (example: home office or rental of a spare bedroom).
In terms of the $250,000/$500,000 capital gains tax exclusion, the gain on the office or rental portion generally qualifies as part of the primary home. However, if depreciation deductions were taken in the past for the office or rental space, then this would be subject to “unrecaptured Section 1250 gain.” More on this below (#5).
3. Selling a Vacation Home
Sadly, gains from the sale of a vacation home doesn’t qualify for the $250,000/$500,000 capital gains exclusion. Instead, the gains will be subject to the normal capital gains tax rate of 0%, 15% or 20% (income dependent) plus 3.8% for upper-income individuals. And as with a primary home, you can’t deduct a loss on the sale of a vacation home (as opposed to a rental property).
4. Vacation Home converted to Primary Home
This one might sting a bit. If you convert a vacation home to your primary residence and live in it for at least two years, you will still NOT qualify for the FULL $250,000/$500,000 capital gains tax exclusion.
Selling a main home that was previously used as a vacation home, some or all of the gain is ineligible for the exclusion. The portion of the gain that is taxed is “based on the ratio of the period of time after 2008 that the home was used as a second residence or rented out, to the total time that the seller owned the house. The remaining gain is eligible for the $250,000/$500,000 home-sale exclusion.”[1]
5. Selling a Rental Home
As with selling a vacation home, a rental home is subject to the same capital gains tax rates (0%,15%,20%, +3.8%) assuming it was held for at least one year. However, one of the most attractive attributes of rental property is the ability to take yearly deprecation deductions. However, these depreciation deductions come at a trade-off. “When depreciable real property is sold at a gain, the rule requires that previously deducted depreciation be recaptured into income and taxed at a top rate of 25%. This is known as the unrecaptured Section 1250 gain.”[2]
Example: You bought a rental house for $300,000 and deducted $109,000 of depreciation and sold the property for $500,000 this year. The first $109,000 of your $200,000 gain is uncrecaptured Section 1250 gain taxed at a max rate of 25%, while the remaining $91,000 is taxed at the regular long-term capital gains tax rates.
This 1250 gain can also apply to the sale of your main residence if you took depreciation for it in the past, such as converting a rental property into your primary home or if you had an office in the home.
If you happen to sell your rental property at a loss, then you can offset your capital gains, plus up to $3000 of other income.
6. Like-Kind Exchange (1031)
A popular investment exchange for real property (e.g. business or investment), under the Section 1031 of the tax code, allows for deferred capital gains taxes. This allows investors to defer all or part of the gain that would have otherwise been realized. When it comes to real estate, this can be used only for investment property, and not main or vacation residences. Investment property exchanges can vary, from vacant land, single family, to multifamily. Contrary to popular misconception, it is not limited to a specific type of property. For instance, a duplex can be “1031ed” into a single family property.
With rental property, capital gains taxes can be deferred indefinitely with a series of 1031 exchanges (so long as the owner never cashes-out). If the property is passed on to an heir, the cost basis, for tax purposes, is updated to the current market value. So if the heir chooses to sell immediately, no taxes would be due. Many investors use this strategy to never pay capital gains and pass their wealth to their heirs completely tax-free.
One thing to be cognizant of is that Washington State has its own sales tax on property called “excise tax.” Upon the sale of a property, the seller pays a percentage of the sales price automatically to the State. Like the federal income tax, it is a progressive tax where you pay at each tier you reach. Below is a table that breaks down how this tax is applied. For more information, see this link.
