The run-up in New York City real estate prices over the last several years, mainly for Manhattan and certain Brooklyn neighborhoods has an unfortunate consequence. When you are ready to sell, you should be prepared that the government expects its share in the form of capital gains.
We have covered capital gains taxes for real estate investors and ways to use depreciation and 1031 exchanges in tax planning, but these are not available to individuals. Whether you are planning on purchasing or selling a home, it is essential to learn about capital gains, and how you can mitigate your liability.
What is a capital gain?
Houses are considered a capital asset, even residences that you live in. The IRS defines capital gains and losses as the difference between the “adjusted basis” and the sales price you received for the capital asset.
The adjusted basis is the cost of the asset, plus any expenditures for improvements that are expected to have a useful life of more than a year. If you gutted the bathroom and put in new kitchen cabinets, these would get added to your initial cost to purchase the apartment and lower your capital gains tax down the road. Routine maintenance, such as painting, do not get added to your cost
Of course, it is a good idea to keep receipts for these major projects in case the IRS asks for proof.
Turning to the selling price, you should deduct expenses. These include the real estate commission and legal fees, to determine the amount realized.
Short-term versus long-term
It is essential to know whether your gain/loss is long-term or short-term. Holding your apartment for more than a year, which is the case for most people, qualifies the capital gain/loss as long-term.
Long-term capital gains are taxed at more favorable rates than those held for the short-term. While short-term tax rates are the same as ordinary income tax rates, which top out at 39.6%, long-term capital gains range from 0% to a top rate of 20%.
If you are in the 10% or 15% tax bracket (2016 incomes up to $75,900 for those married filing jointly), your long-term capital gains tax rate is 0%. If your income is taxed in the 25%, 28%, 33%, and 35% brackets (incomes from $75,901 to $470,700), your gain is taxed at a 15% rate. The top tax rate, 20% is for those in the 39.6% income tax bracket (joint filers with income of $470,701 and above).
A one-time break
The government has provided a generous provision for homeowners that allows you to exclude a significant portion, up to $500,000 if filing jointly ($250,000 for others) of a capital gain. You have to meet the ownership and use requirements, but these are not restricted to single family owners, and apply to co-op and condo owners.
If you owned the home and lived in it for at least two of the past five years before the sale, you qualify for this nice break.
Another way to minimize the gain
The IRS lets you deduct capital losses from your capital gains. If you determine to sell other investments and realize the loss, you can offset the gain in your home. Since the IRS only allows a maximum capital loss of $3,000 in one year, you may have losses in prior years that you can roll forward. For instance, if you had a $10,000 loss from the sale of stocks, you can claim a $3,000 for the first three years and $1,000 for the fourth year. For simplicity sake, if you sell your home the same year as the loss was incurred, and have a $20,000 gain (after the $500,000 exclusion), you can use the $10,000 loss, and only pay a capital gains tax on $10,000.
Withholding for foreigners
When a foreigner sells U.S. real estate, he/she is subject to the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA). This means you are required to have 15% of the amount realized (sum of cash paid, FMV of other property transferred and any liability being assumed).
We have explained capital gains for individuals. If you are an investor and formed an LLC, you still benefit from the lower capital gain tax rates. However, the situation is more complicated. For instance, you can deduct depreciation annually, which is only allowed for investment properties. This deferred your taxes, but when you sell it, the depreciation is “recaptured,” and you pay a 25% rate on the amount you claimed for depreciation throughout the years. A 1031 exchange allows you to postpone capital gains taxes, although there are conditions, such as using the proceeds to invest in a similar property (although you have wide latitude)
We have seen that the government seeks to encourage real estate ownership with favorable tax treatment. Proposals being bandied about the Trump administration would lower the rates further, although completion is a long way off, and the outcome is far from certain.