If you own a home or other real estate in Lake Forest, Illinois, knowing that your property has increased in value can be a nice feeling. But, if you decide to sell your property, the IRS may take a portion of your proceeds because capital gains from real estate sales can be taxed. Whether you're planning to sell your home or an investment property, there are tax breaks and exclusions that can help you maximize your profit. At Pasquesi Sheppard, we've compiled this helpful guide to explain how to avoid or minimize capital gains tax on real estate.
Understanding Capital Gains Tax on Real Estate
To effectively reduce tax on capital gains from property sales, you should have a basic understanding of how it works, including phrases and concepts related to capital gains tax.
Definition and Overview of Capital Gains Tax
In the context of real estate, capital gains refer to the increase in value of your property since its purchase or acquisition. It's referred to as the increase in purchase price. If you sell your property for a higher price than what you paid for it, 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 sales is progressive, meaning your tax rate rises as your income increases.
Difference Between Long-Term and Short-Term Capital Gains
Another factor affecting capital gains tax on real estate is the length of time you've owned the property. A long-term capital gain is the profit from selling a property after more than one year of ownership. In this case, your tax rate will be calculated using your taxable income. Profit from the sale of a property held for up to one year is considered a short-term gain and is taxed at the same rate as your ordinary income. Taxes on long-term gains are typically more lenient, with many people qualifying for a 0% tax rate.
Calculating Capital Gains on Real Estate
As mentioned above, a capital gain is the net profit from the sale of a property. It's calculated by subtracting the cost basis or adjusted cost basis of your property from the selling price. Your cost basis is the total amount you spent for your home, including commissions, transfer fees, and other expenses related to the purchase. The adjusted basis is the total cost basis plus any capital improvement costs, less casualty loss amounts and other deductions. Depending on the circumstances, it can increase or decrease with time.
Example Calculation of Capital Gains
Let's look at an example of how to calculate capital gains from property sales. Suppose you spent $350,000 buying your Lake Forest property and you made no improvements or losses over your 10-year stay. Then you sell it for $450,000. Deduct your $350,000 cost basis, 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 sales can cost you thousands of dollars. Fortunately, you can take measures to reduce or avoid capital gains tax on real estate.
Utilizing the Home Sale Exclusion
There are exceptions to capital gains regulations when selling a home that can help you avoid paying capital gains tax. One of them is passing the ownership test and the use test. You're only eligible for this if you're selling your principal or primary residence, which is the home where you've spent the majority of the tax year. You must have lived there for a minimum of two years over a five-year period before selling it. The 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. The threshold is $250,000 for individual filers or $500,000 for joint filers.
Employing Like-Kind Exchanges (IRC Section 1031)
Another way to reduce your capital gains tax on real estate is a like-kind exchange, also known as IRC Section 1031. Such a transaction involves selling one property and purchasing another of similar value. This allows 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 that qualifies you for a lower tax rate.
Converting Second Homes Into Primary Residences
To qualify for the capital gains tax deduction on a primary residence, you can convert your second home or investment property into your primary residence. Ensure the property is close to your workplace, bank, and other amenities. Use its address on official documents, such as your driver's license, tax returns, and voting registration, to strengthen its property status.
Timing Your Sale for Tax Advantages
Spreading your property sale earnings over multiple tax years can help you remain in your current tax bracket or drop to a lower one. Get the buyer to purchase your property in installments rather than a lump sum. You should receive one or more payments after the tax year in which the sale occurred. When filing your taxes, report income from your sale on IRS Form 6252 under Part 11 Installment Sale Income and attach it to your return.
Consult a Tax Expert in Lake Forest Today
Reducing or avoiding capital gains tax on your 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 our property tax experts at Pasquesi Sheppard. We have extensive experience in the real estate industry and can help you navigate capital gains tax based on your situation, allowing you to get the most out of your property sale. Contact us today to schedule a consultation.