The capital gains tax is economically senseless. The tax traps wealth in an investment vehicle requiring special techniques to free the capital without penalty.
Multiple ways are available to avoid the tax, but none are beneficial to the economy.
Investing in rental properties can supply investors with steady revenue streams that cover the mortgage while providing some extra profits each month. And when such properties are ultimately sold, investors stand to enjoy substantial windfalls. But these selling events can trigger significant long-term capital gains tax liabilities. Case in point: in 2020, that tax rate is 15% if you’re married filing jointly with taxable income between $78,750 and $488,850. And if your income is $488,851 or more, the capital gains rate spikes to 20%.
It feels great to get a high price for the sale of your home, but watch out: The ATO may want a piece of the action. That’s because capital gains on real estate are taxable sometimes. Here’s how you can minimize or even avoid a tax bite on the sale of your house.
When you sell your home, the capital gains on the sale are exempt from capital gains tax. Based on the Taxpayer Relief Act of 1997,1 if you are single, you will pay no capital gains tax on the first $250,000 you make when you sell your home. Married couples enjoy a $500,000 exemption. There are, however, some restrictions on this exemption.
What Is Capital Gains Tax?
The capital gains tax is essentially a tax on any gains you realize after the sale of an asset, like real estate, bonds, jewellery, coin collections, or stocks.
There are a few ways you could end up paying this tax on your home.
For instance, if you decide to sell your primary residence less than a year after moving in, you would be subject to a capital gains tax.
And there are also ways to avoid this tax; for example, if you sell your home after two years.
Some exclusions also allow you to avoid being taxed up to a certain amount.
The theory is that the money you used to purchase the asset was already subject to taxation at some point, which is why the government only taxes the difference after the sale.
So, for instance, imagine you bought an asset for £10,000 and sold it for £15,000. As a result of the sale, you’ll have made a profit of £5,000. The government will not tax you on £15,000. Instead, the CGT will kick in for the gain that you made, which is £5,000.
The UK defines disposing of an asset as:
- Giving the support away as a gift
- Selling it
- Transferring it to another party
- Receiving compensation, such as in the form of an insurance payment
- Trading or swapping for another item
Additionally, the government requires you only to pay the capital gains tax if the gains you make throughout the year on a sale exceed what is known as the Annual Exempt Amount (AEA). The tax-free allowance is £11,700 for individuals and £5,850 for trusts. Keeping your profits below this threshold is an excellent way to avoid capital gains tax on property.
The tax-free allowance has also increased over the past couple of years.
- In 2017-18, the limit was 11,300 pounds.
- In 2019-20, the rate increases from £11,700 to £12,000.
Knowing what the threshold is going into the year allows you to make strategic decisions when selling an asset. It would be best if you also were mindful of the couple’s allowance rate, which is £23,400 in 2018-19 and £24,000 the next year.
Lastly, this guide will primarily focus on the best ways to avoid capital gains tax on property, but it’s worth mentioning that the CGT can apply whenever you sell a wide range of assets. For instance, practically all personal possessions worth £6,000 or more, besides your car, are subject to the tax. The tax also applies to business assets and shares not contained in a PEP or an ISA.
How does a capital gains tax work?
- The ATO and many states assess capital gains taxes on the difference between what you pay for an asset — your basis — and what you sell it for.
- Capital gains taxes can apply to investments, such as stocks or bonds, and tangible assets like cars, boats and real estate.
Until 1997, once you reached the age of 55, you had the one-time option of excluding up to $125,000 of gain on the sale of your home providing it was your primary residence.
Now, anyone, regardless of age, can exclude up to $250,000 of gain or $500,000 for a married couple filing jointly on the sale of a home. That means most people will pay no tax unless they have lived there for less than 2 out of the last five years.
How to avoid capital gains tax on a home sale
The UK defines a few scenarios that make avoiding capital gains tax on a property sale possible. This is primarily the case when a resident sells their home. Residents must meet all criteria to avoid the capital gains tax on a property sale. First and foremost, the house that the resident is selling should be the primary residence. It must be the only home that the resident has.
The home that the resident is selling should have served as the primary home for the entire time that he or she has owned it. Additionally, the owners should not have let part of it out to others, although this component does not apply if there is a single lodger in the home. Furthermore, owners should not have used part of the house strictly for their business.
This part, in particular, could become more challenging over the years, and loophole to avoid capital gains taxes could grow smaller. That’s because more and more people are beginning to work from home or start their own business. When doing so, they may list their home address as their business address. If the government has a record of this, it will require the homeowner to pay CGT upon selling the house.
Furthermore, the entire property must be less than 5,000 square metres. This not only includes the buildings on the property but the grounds themselves. Those who live in the countryside and own substantial land could find themselves subject to the CGT unless they choose to sell the land separately from home.
Lastly, homeowners must be able to demonstrate that they didn’t buy the structure merely to make a gain. For those who have lived in the unit for years to declare it as their primary residence, this should not be a problem. However, this component could become problematic for those who flip homes. If you purchase a home as a fixer-upper or as an investment, you’ll likely have to pay CGT upon sale.
The government says that if homeowners meet all of the above criteria when selling a home, they do not have to do anything. They’ll receive a tax break, known as Private Residence Relief, automatically. However, if you don’t meet all of the above criteria, avoiding the capital gains tax could become more complicated, and you should prepare yourself to pay the fee at the end of the year.
In some instances, you can treat part of your profit as tax-free even if you don’t pass the two-out-of-five-years tests. A reduced exclusion is available if you sell your house before passing those tests because of a,
- change of employment,
- transformation of health, or
- other unforeseen circumstances, such as a divorce or multiple births from a single pregnancy.
So, if you need to move to a more prominent place to find room for the triplets, the law won’t hold it against you.
Note: A reduced exclusion does NOT mean you can exclude only a portion of your profit. It means you get less than the full $250,000/$500,000 exclusion. For example, if a married couple owned and lived in their home for one year before selling it, they could exclude up to $250,000 of profit (one-half of the $500,000 because they owned and lived in the home for only one-half of the required two years).
How Much Is Your Gain?
Many people mistakenly believe that their gain is simply the profit on the sale: “We bought it for $100,000 and sold it for $650,000, so that’s a $550,000 gain, and we’re $50,000 over the exclusion, right?”. It’s not so simple — a good thing, since the fine print can work to your benefit in such instances.
Your gain is actually your home’s selling price, minus deductible closing costs, selling costs, and your tax basis in the property. (Your seed is the original purchase price, plus purchase expenses, plus the cost of capital improvements, minus any depreciation and minus any casualty losses or insurance payments.)
Deductible closing costs include points or prepaid interest on your mortgage and your share of the prorated property taxes.
Examples of selling costs include real estate broker’s commissions, title insurance, legal fees, advertising costs, administrative costs, escrow fees, and inspection fees.
So, for example, if you and your spouse bought a house for $100,000 and sold for $650,000, but you’d added $20,000 in home improvements, spent $5,000 fixing the place up for sale, and paid the real estate brokers at least $25,000, the exclusion plus those costs would mean you’d owe no capital gains tax at all.
State taxes are added on to federal capital gains tax rates and vary depending on your location. California has the highest US capital gains rate and the second-highest internationally, with a top speed of 37.1%.
In the United States, seven states add nothing to the top federal rate of 23.8%: Alaska, Florida, South Dakota, Tennessee, Texas, Washington and Wyoming. No national value is added by moving, although individuals can undoubtedly gain from living in a state that taxes their particular assets favourably.
Keep the receipts for your home improvements.
“The cost basis of your home not only includes what you paid to purchase it but all of the improvements you’ve made over the years,” says Steven Weil, an enrolled agent and president at RMS Accounting in Fort Lauderdale, Florida. When your cost basis is higher, your exposure to the capital gains tax is lower. Remodels, expansions, new windows, landscaping, fences, new driveways, air conditioning, installs — they’re all examples of things that can cut your capital gains tax, he says.
Sharp real estate agents and home renovators make their under-market investment purchases their primary residence while they are fixing them up. They then flip the houses, selling for a better sales price but avoiding any tax on their gains via the primary residence exclusion.
This bizarre game of paperwork adds no real value to the economy. However, the flipped houses do add a lot of value to the neighbourhood, town and economy. The capital gains tax is wrong to discourage such improvement efforts.
Take Advantage of Section 1031 of the Tax Code
Real estate investors can defer paying capital gains taxes using Section 1031 of the tax code, which lets them sell a rental property while purchasing a “like-kind” property, and pay taxes only after the exchange is made. Legally speaking, the term “like-kind” is broadly defined. An investor need not swap out one condo for another or trade one business for another. As long as both properties in question are income-generating rental units, they’re fair game. But timing is key, where investors have just 45 days from the date of a property sale to identify potential replacement properties, which they must formally close on within 180 days. And if a tax return is due before that 180-day period, investors must close even sooner. Those who miss the deadline must pay full taxes on the sale of the original rental property.
See whether you qualify for an exception.
If you have a taxable gain on the sale of your home, you might still be able to exclude some of it if you sold the house because of work, health or “an unforeseeable event,” according to the ATO.
Turn Your Rental Property into Your Primary Residence
Selling a home, you live in is more tax beneficial than unloading a rental property for a profit. For this reason, some investors choose to convert rental properties into their primary residences. Specifically, ATO Section 121 lets people exclude up to $250,000 of the profits from the sale of their primary residence if they’re single and up to $500,000 if they’re married filing jointly. To qualify, investors must own their homes for at least five years and must have lived in them for at least two of those five years. The deduction amount depends on how long the property was used as a rental versus its use as a primary residence.2
For example, let’s assume you bought a house five years ago for $200,000 and rented it out for the first three years, before moving in two years ago. If you then sold the house for $300,000, you will have realized $100,000 in capital gains. But you may deduct two-fifths (40%) of that amount since you lived in the home two out of five years. The remaining $60,000 in profits will be subject to capital gains taxes.
Use Tax-free Home Equity to Accumulate Retirement Wealth
It’s possible to use this tax exclusion on gains to accumulate retirement assets. For example, one particular person was a home builder, and every two years, he bought land and built the family a new home. As soon as they moved into the new house, he would sell the old house and use some of the tax-free money from the sale of that home to begin building the next one.
Although moving every two years is not for everyone, it did allow them to accumulate assets tax-free. Every two years, they would use some of the tax-free gains to build the next home and deposit some into his investment account.
The risk of this strategy: during times where real estate depreciates, this plan won’t work. You could get stuck holding two homes for several years until the market recovers.
Your home is likely your single most valuable asset. It’s nice to know that when you eventually sell it, most of the profit you make won’t go to the ATO.
Health Savings Accounts
HSAs are one of the few accounts where you can receive a tax deduction for contributing to them, invest them and receive tax-free growth and then not pay any taxes as long as you use withdrawals for qualified health expenses. Investing your HSA account to receive tax-free growth is another way to avoid paying the capital gains tax.
However, all of the tax-advantaged accounts just described are further paperwork at the end of the day. No real economic value is gained from this complicated shuffle of assets, even though you benefit by retaining more of your assets.
Buy and hold
Many investors buy good index funds that never need to be sold. Even if you rebalance regularly, rebalancing can often be accomplished by using the interest and dividends paid to purchase whichever investments need to be bolstered. The downside is that your capital is locked inside the investment vehicles and not free to be used for greater economic gain.
Marriage and Divorce
If you’re married, $500,000 of gains on the sale of a home are excluded from taxable income. However, if you go above that amount, you’ll have to pay gains tax on anything above it.
For example, if you purchased a home four years ago for $600,000, and now you sell it for $1.2 million. Your gain would be $600,000, which is $100,000 above the $500,000 limit; therefore, you would have to pay taxes on that $100,000.
You don’t have to occupy the residence in consecutive years to qualify for the exemption, either.
Married couples filing jointly may exclude up to $500,000 in gain, provided:
- either spouse owned the residence
- both spouses meet the use test, and
- neither spouse has sold a residence within the last two years.
Separate residences. If each member of a married couple owns and occupies a separate residence and files jointly, each may exclude up to $250,000 in gain when they sell. Also, if it’s a new marriage and one spouse sold a residence within two years before the marriage (thereby disqualifying him- or herself from the exclusion), the other spouse may still exclude up to $250,000 in gain on a residence owned before the marriage.
Double tax breaks? A new marriage may also double the tax break in some circumstances. Suppose a single man sold his principal residence on October 1 and gained $500,000 in profits. Let’s also say that he and his girlfriend had been living in the house for two years (but her name wasn’t on the title), so they both satisfy the use test. If they get married by midnight December 31 of the same year, they can file a joint return for that year and exclude the entire $500,000.
Divorce and the tax break. Divorced taxpayers may tack on the ownership and use of their residence by their former spouse. For example, say that upon divorce, the wife is allowed to live in the husband’s residence until she sells it. He has owned the residence for 18 months. Once the sale occurs, the couple will split the profits 50-50.
If the wife sells the home nine months later, she may tack on her ex-husband’s ownership to meet the two-year ownership test. Also, the husband may tack on his ex-wife’s continued use of the residence to meet the two-year use test. Each one is entitled to exclude $250,000 of profits from the sale. Widowed taxpayers may also tack on the ownership and use by their deceased spouse.
Home Offices: A Tax Drawback
The exclusion does not apply to depreciation allowable on residences after May 6, 1997. If you are in a high tax bracket and plan to live in your home for a long time, taking depreciation deductions for a home office is quite valuable right now. But if not, you might want to reconsider using a portion of your home as an office, because all depreciation deductions you take will be taxed at 25% when you sell the house.
Example: A married couple sells a home with an adjusted basis (purchase price plus capital improvements) of $100,000 for $600,000. Over the years, they had taken $50,000 in depreciation deductions for a home office.
Sales Price: $600,000
Adjusted Basis – $100,000
Taxable gain = $500,000
Of that gain, $450,000 is tax-free; the $50,000 taken as depreciation deductions is subject to 25% capital gains tax.
The Bottom Line
Capital gains taxes can take a sizable chunk of profits from your rental property sales, to the tune of 15% or 20% of your take. Fortunately, capital gains tax avoidance and deferment strategies can help ease that burden.
The bad news about capital gains on real estate
Your $250,000 or $500,000 exclusion typically goes out the window, which means you pay tax on the whole gain if any of these factors are true:
- The house wasn’t your principal residence.
- You owned the property for less than two years in the five-year period before you sold it.
- You didn’t live in the house for at least two years in the five years before you sold it. (People who are disabled, and people in the military, Foreign Service or intelligence community can get a break on this part, though; see IATO Publication 523 for details.)
- You already claimed the $250,000 or $500,000 exclusion on another home in the two-year period before the sale of this home.
- You bought the house through a like-kind exchange (basically swapping one investment property for another, also known as a 1031 exchange) in the past five years.
- You are subject to expatriate tax.
The good news about capital gains on real estate
The ATO typically allows you to exclude up to:
- $250,000 of capital gains on real estate if you’re single.
- $500,000 of capital gains on real estate if you’re married and filing jointly.
For example, if you bought a home ten years ago for $200,000 and sold it today for $800,000, you’d make $600,000. If you’re married and filing jointly, $500,000 of that gain might not be subject to the capital gains tax (but $100,000 of the revenue could be).