Selling your home is exhausting and expensive enough without the stress of surprise taxes and fees.
When putting your house on the market, taxes are inevitable. But few strategies can help you hold on to more of your money. As home prices continue to surge, here’s how to minimize how much you pay on your profits — also called a capital gains tax.
We all know the old saying – the only certainties in life are death and taxes. But when it comes to selling your property, capital gains tax might turn out to be one thing that you don’t have to bank on.
Okay, perhaps ‘breathtaking’ is a little much. But when it comes to getting people excited about capital gains tax exemptions, desperate times call for desperate and misleading adjectives. Now, the bad news: selling your investment property (or properties) and avoiding paying more tax than you need to be paying can be mind-numbingly complicated.
What is capital gains tax?
Cars, stocks, and bonds can be capital assets. A home is considered a capital asset, too, because it’s a significant piece of property. When you sell a property for more than you paid, it’s called a capital gain.
When you sell a car for more than you paid, you’ll need to report that gain to the ATO. The ATO will then tax your capital gains. Homes get excluded from capital gains tax — as long as you and your home fit the criteria.
Selling your home is exhausting and expensive enough without the stress of surprise taxes and fees.
When putting your house on the market, taxes are inevitable. But few strategies can help you hold on to more of your money.
As home prices continue to surge, here’s how to minimize how much you pay on your profits — also called a capital gains tax.
A capital gains tax is a fee that you pay to the government when you sell your home, or something else of value, for more than you paid for it. For example, if you bought a house years ago at $200,000 and sold it for $300,000, you’d pay a percentage of your $100,000 profit — or capital gains — to the government.
When you make money from selling a house or property, your capital gains tax depends on whether you lived in the house and how long you lived there.
Your Investment Property asked chartered accountant and practising lawyer, Michael Quinn, to explain some little known ways to avoid CGT when turning your home into a rental property.
One downfall to renting out an investment property is the capital gains tax (CGT) that will be payable upon the sale of the property. CGT is the tax charged on capital gains that are procured from an asset. You are liable to pay this tax when your capital gains exceed your capital losses in an income year.
However, there are legal ways to avoid paying CGT while renting out your house. Capital gains tax exemptions are allowed by the Australian Taxation Office (ATO) under certain scenarios.
People’s lives are constantly changing. Whether it’s due to a change in future plans or circumstances, there are many reasons why you may decide to lease out your main place of residence. To do this without incurring CGT, be sure to understand the ATO’s rulings with regards to this topic.
How Much Will I Have To Pay?
Most taxpayers miscalculate their capital gains by simply subtracting the purchase price from the selling price. But under the tax code, “purchase price” and “selling price” are much more.
Your purchase price — or “cost basis” — is what you paid for the house or property plus all the taxes and fees you paid when you bought it, typically from 2% to 5% of the cost. You can also include money spent on projects that added value to the property, like that extra bathroom or garage improvements.
On the other end of your investment, your selling price is what you sell your property for minus any commission or closing fees you pay to sell it.
Let’s say that years ago you paid $200,000 for a house. At that time, you paid $8,000 in taxes and closing fees. Since then, you’ve made $30,000 in improvements. In this case, your cost basis is $238,000.
When you sell real estate you’ve held as an investment, the rate at which you’re taxed for making a profit from it may vary depending on how long you’ve held it, and whether it is a home or other type of real estate.
Home sales, being a specific type of capital gains, have their own set of rules.
Profits from selling something you’ve held less than a year are taxed as “short-term” capital gains and are pegged to your income tax bracket. You’ll pay short-term capital gains at the same rate you pay your income taxes, which vary depending upon your income.
As it counts towards your income tax, CGT isn’t a stand-alone amount, but rather a levy calculated based on the capital gain made from the sale of the home, which is then included in your assessable income in your tax return for that year.
If you’ve bought and sold a property within 12 months, your capital gain is added to your income – easy. But if you’ve owned your property for longer than 12 months before selling, there are some calculations to do.
There are two different methods used for figuring out how much CGT you need to pay – discount and indexation – and you can choose whichever method gives you the smaller capital gain (and therefore lesser CGT amount).
How To Qualify For Capital Gains Tax Exemptions?
During a hot housing market, sellers can expect to make a hefty profit. To avoid capital gains tax on your home, make sure you qualify:
- You’ve owned the home for at least two years. This might be troublesome for house-flippers, who could be subjected to short-term capital gains tax. This is applied if you’ve owned a home for less than one year—more on that below.
- You’ve lived in the home for at least two years. The house you’re selling should be your primary residence, even if the two years you lived there weren’t consecutive.
- You haven’t done this recently. As long as you haven’t exempted the gains on another home sale in the last two years, you’re safe.
Steven Wolpow, the managing partner of Nussbaum Yates Berg Klein & Wolpow, says the pros are high for homeowners.
“The benefits for owners are obvious,” he says. “There is a tremendous tax advantage when you sell your home at a gain, and this is something that you can repeat again and again.”
While there are limitations on how soon you can benefit from the exclusion after you’ve done it recently, there is no shortage of how many times you can take advantage of it. But there are some limitations.
“(Homeowners) have to keep good records of how much they paid for their home and how much they spent on improvements,” he says. “Also, homeowners have to be aware of the requirement to have used the home for the required period to take advantage of the exemption.”
If your property isn’t exempt from the capital gains tax, here are a few strategies to minimize or reduce it.
Live In The Property For At Least 2 Years
To get around the capital gains tax, you need to live in your primary residence at least two of the five years before you sell it.
Note that this does not mean you have to own the property for a minimum of 5 years, however. Once you’ve lived in the property for at least 2 years, you’d reach capital gains tax exemption.
The short answer is 12 months – but it’s a fair bit more complicated than that! Whether or not you pay capital gains tax (or CGT), how long you have to wait to receive exemptions or reductions, and how much you pay depends on a few different factors. For example, what the property has been used for (was it your main residence, or an investment property? Did you run a home business from home?), as well as how long you’ve owned the property.
If you have owned the property for at least 12 months as an individual, you are eligible for a 50% discount on payable tax for your capital gains. Secondly, use a capital gains tax calculator to you work out what you may owe come tax time.
In Australia, you must own and use the home as your main home for two years before selling the home to exclude a portion of the capital gain from tax. As a single tax filer, you may qualify to exclude up to $250,000 of capital gain from your income, or up to $500,000 of the capital gain if you file a joint return with your spouse. This is the Section 121 exclusion.
If you sell your primary home, it could be entitled to special treatment, even if the sale gave you a six-figure profit. However, it’s not as simple as selling a home you live in. To get the primary residence exclusion, you need to meet two conditions:
- You need to have owned the home for at least two out of the previous five years.
- You need to have lived in the home as your primary residence for at least two of the previous five years.
These conditions don’t necessarily need to be met during the same two years, but the key takeaway is that there’s a two-year time requirement at an absolute minimum. And you can only use the exclusion once every two years. In other words, if you buy a home and sell it a year later, you can’t use the exclusion, regardless of whether it was your primary home during your ownership.
If you qualify, the primary residence exclusion can exempt as much as $500,000 of net profit from capital gains tax for married couples filing jointly, or $250,000 for all other taxpayers. So if your cost basis in your home that you own jointly with your spouse is $400,000 and you eventually sell it for $900,000, the ATO can’t touch a penny of your gains.
How Much You Can Exempt From Capital Gains?
If you meet the qualifications, how much you can exclude is dependent on your filing status. It’s up to $250,000 for single people and up to $500,000 for married couples filing jointly. To find out how much your capital gain is, subtract the purchase price from the sale price.
“Let’s say a couple bought a home in 2010 for $150,000 and owned and lived in it until they decided to take advantage of a seller’s market and sold it for $250,000 in 2018”, Cawley says. “Their’ gain’ on their house would be $100,000, which would have no tax implications because they met all the requirements for capital gain exclusion, and the gain can be left off their tax return altogether.”
Now, there’s more good news. Based upon ATO exclusion, if you sell the main home you live in, the ATO lets you exclude — not be taxed on — up to $250,000 of capital gains on real estate if you’re single. If you’re married and file your tax return jointly, the ATO is even more generous, letting you exclude typically up to $500,000 in capital gains. That’s thanks to a Taxpayer Relief Act of 1997. You’re eligible for the exclusion if you have owned and used the home as your main home for a period totalling at least two years out of the five years prior to its date of sale.
Let’s say you bought a home ten years ago for $200,000 and sold it now for $500,000. You made $300,000. If you’re married and filing jointly, none of that gain would be typically subject to the capital gains tax. If, however, you sold it for, say, $800,000, up to $500,000 of your gain would be excluded, but you’d possibly be subject to paying capital gains on the $100,000 of that gain — the amount over $500,000.
However, a number of factors could make it so you can’t take the exclusion allowed when selling your home. Items that disqualify you from taking the standard exclusion on your capital gains include if you’re subject to expatriate tax; the house or real estate you sold wasn’t your principal residence (use requirement); you owned it for less than two years in the five years before you sold it (ownership requirement), or you didn’t live there for at least two years in the 5-year period before you sold it.
Your partnership matters for the exemption as well. As long as your partner lived in the home for at least two years, they qualify, too. You don’t have to be married for that time either — just cohabitating.
It’s also important that neither you nor your spouse has sold a home and used the capital gains tax exemption within the last two years.
To qualify for a total CGT exemption, the property must have been your main residence from when you acquired it. If you move out of the property and rent it out, you can continue to claim an exemption from CGT for up to six years after you move out. If you do not rent it out, you can claim a CGT exemption for the property for an indefinite period after you move out.
Moving from your main residence could be for reasons such as:
- Accepting a new job interstate or overseas
- Staying with a sick relative long term
- Going on an extended holiday
A taxpayer can still apply the six-year exemption rule if they acquire and reside in another property. However, there is no ‘Main Residence’ exemption applied to the second property, which subsequently becomes subject to capital gains tax.
In situations where multiple investment properties are acquired over the period, the ATO sees the six years as cumulative. This denotes that you only get six rental years in total before you are liable to pay CGT. Fortunately, the CGT will be exacted proportionately, for instance, if you made a $200,000 capital gain on a property that you rented out for eight years, you will only have to pay CGT for the two-year period that exceeds the six-year exemption.
Thus, the CGT will be exacted on $50,000, then take into account the 50% discount for holding property for over 12 months and this gets dropped down to $25,000. You will be able to verify whether or not this exemption applies to you via the ATO website, or through a CGT knowledgeable accountant.
When in doubt, ask for help!
Homeownership often comes with the headache of ultimately selling your home. By knowing more about the intricacies of the capital gains tax, you could line up your sale to maximize the profits you make on your home or investment property. And save a big headache at tax time.
As a final point, it’s important to emphasize that there is no way I can go over every potential real estate sale situation in this article, and there’s admittedly some grey area in the tax code. For example, maybe you made an absolute repair/improvement during your ownership, and you aren’t sure whether it should be added to the property’s cost basis.
In situations like this, it’s essential to seek the advice of a qualified professional, such as a tax attorney or a reputable and experienced tax professional. Ideally, look for one who specializes in real estate issues. High-dollar tax issues, like real estate capital gains, have the potential to be, are closely watched by the ATO, so it’s not only important to seek advice to make sure you maximize your tax breaks, but to make sure you’re doing it correctly.