In many cases, if you sell real estate for more than you paid for it, you will owe capital gains tax on the real estate to the ATO. The same is true for other types of investments, including securities like stocks and bonds. There are, however, legal ways of avoiding capital gains tax on the sale of a home through ATO-approved exclusions. You can also sometimes avoid capital gains tax on real estate for business use by buying other real estates with the proceeds.
You own an investment property. Since you bought it, the value has just gone up and up—the thought of unlocking that equity has you dreaming of far-flung destinations and shiny new toys. But before you crack open that nest egg, make sure you do your research.
Knowing the implications of, and how to avoid, capital gains tax when selling an investment property could save you a small fortune. In this post, you’ll learn what it is, when it applies and tips to reduce the taxes on selling a house.
Capital Gains Tax Basics
A capital gain occurs when the sales price you received for an asset is greater than your basis in that asset. The “basis” of an asset may be the price you paid for it. However, if you’ve made improvements to the asset, the cost of the improvements increases your basis. If you’ve depreciated the asset, that decreases your basis.
Capital Gain Tax Rates
There are two different tax schemes for capital gains:
- Short-Term Capital Gains are gains on assets you have held a year or less. Short-term capital gains are taxed at the same rates as ordinary income. This is the same rate that you pay on work wages, freelancing income, or interest income. The tax rate you must pay varies based on your total taxable income, but the tax rates for 2019 are between 10% and 39.6%.
- Long-Term Capital Gains are gains on assets you have held longer than one year. Long-term capital gains are taxed at more favourable rates. Current tax rates for long-term capital gains can be as low as 0% and top out at 20%, depending on your income. Gains on the sale of collectibles are taxed at 28%.
Exclusion for Sale of Primary Residence
Special rules apply to the capital gains when you sell your primary residence. If you meet the ownership and use tests, you can exclude up to $250,000 if you are unmarried, or $500,000 if you are married and filing a joint return. The tests mentioned are met if you own and use your house as your primary residence for two out of the five years immediately preceding the date of sale.
You can meet the ownership and use tests for different two-year periods, but both tests must be met within the five years immediately preceding the date of sale. This exclusion of capital gains is sometimes referred to as a Section 121 exclusion.
Reporting and Paying Capital Gains
Capital gains are reported on your annual tax return, along with income from other sources. Capital gains transactions are reported on Schedule D. Sales of securities are reported on Form 8949. Total capital gains or losses (limited to $3,000) are reported on Form 1040, line 6. If you use tax preparation software like H&R Block, you’ll be able to easily enter your capital gain numbers for calculation in your tax liability.
Unlike wages, there are no automatic federal or state taxes withheld from your capital gains proceeds. Therefore, if you have significant capital gains, you may need to make estimated tax payments to the ATO throughout the year.
Complete the worksheet on Form 1040-ES to check whether you need to make estimated tax payments to the ATO. Estimated tax payments are due on April 15, June 15, September 15, and January 15 of the following tax year if that date falls on a weekend or holiday, the due date shifts to the next business day.
When Must You Pay the CGT and What Are the Rates?
You are required to pay capital gains tax on any property that is not your main home. The government will also make you pay the tax on your main home under specific criteria.
If the house is rather large, was used for business, or has been let out, then avoiding capital gains tax on the property could be challenging.
Additionally, the CGT rates on the property are higher than the asset rates.
A primary ratepayer will need to pay a ten per cent CGT rate on all assets. However, the same individual would need to pay a CGT rate of 18 per cent on all property.
There is also a higher additional payer rate for both categories. The additional-rate payer will need to give a CGT of 20 per cent on assets. However, the higher-rate payer would need to pay an astounding 28 per cent CGT on a property.
How Much Will I Pay in Capital Gains Tax?
When searching online, you will likely come across a capital gains tax on property calculator. The formula that these calculators use is primarily the same.
We’ve taken the time to provide you with the method used for a capital gains tax on property calculator so that you can estimate how much you’ll need to pay next year.
First, you’ll want to know your income. You will either be subject to tax at the basic rate or the higher additional ratepayer.
If your income defines you as a basic-rate payer, you could make enough on capital gains tax to push you into the additional-rate payer category. If this is the case, you’ll only pay the 28 per cent tax on the amount that takes you over the threshold.
Offset With Capital Loss
Long-term capital gains tax rates are generally lower than the ordinary income rate you pay on income from work and other earnings like bank interest. However, they can still add up if you had a highly profitable investment. If you’ve lost money on investment at the time you sell it, or you had stock or something else that became worthless, you can write off the money you’ve lost as a capital loss.
A capital loss can offset capital gains or up to $3,000 in ordinary income on your taxes, and you can roll capital losses into future tax years to offset future capital gains and income. However, you can’t roll them backward to offset previous earnings. This means it can be worthwhile to balance the sale of a profitable asset with one that has lost money. An online capital gains tax calculator on the sale of property or a professional tax adviser can help you estimate what you owe.
Selling Your Home for Gain
Special rules apply if you sell your main residence for a capital gain. You can generally exclude up to $250,000 in capital gains from taxation or up to $500,000 for married couples filing joint provided you meet the ATO requirements. Specifically, you need to have owned the house and used it as your main home for two years within the five years before the home’s sale.
The period where it was your main home and the period where you owned it don’t have to be the same period. If you’re married and filing jointly, only one spouse has to meet the two-year ownership requirement, but both spouses must meet the primary residency requirement to get the tax exclusion.
Some special exemptions to the five-year requirement can apply if you were stationed away from home while in the military, the intelligence services or the U.S. Foreign Service, or if you were physically or mentally unable to care for yourself. You can also apply special rules if your spouse died, you were divorced or separated while owning the home or if your home prior to the one being sold was destroyed or condemned.
You’re also allowed to count the separate sales of vacant land adjacent to your home and your home itself as one transaction for tax purposes in certain situations.
The income exclusion is only permitted for use on one home in any two-year period, even if you’d otherwise meet the requirements on more than one home. If you’re not sure whether the exclusions apply to you, study the ATO materials on the subject and consider working with an accountant or lawyer.
Understanding Like-Kind Exchanges
If you own real estate for a business or investment and you sell it, then quickly buy other real estates, you can defer paying capital gains tax on the initial sale until you sell the new property. This procedure is called a like-kind exchange or, after the section of the tax law that enables it, a 1031 exchange.
The rules around this procedure are somewhat precise, so it is important to make sure you do it in accordance with the law to avoid owing unnecessary tax. Generally, you must have the proceeds of the sale of the initial property transferred to a qualified intermediary rather than receiving cash for sale. Then, you must designate the desired replacement property in writing to the intermediary within 45 days of the sale and close on it within 180 days.
The 1031 exchange generally applies only to business and investment real estate, not your primary home. As of 2018, the 1031 exchange is only used for real estate, not for other investments like securities or artwork.
Like-Kind Exchanges – Boot
If you receive money from the sale, that’s known as boot, and it’s taxable as a capital gain. For example, funds used to pay off a mortgage on the initial property if you don’t have a similarly sized mortgage on the new property would be considered boot.
If you’re not sure whether a transaction can be counted as a 1031 exchange, consider working with an expert, such as a lawyer or accountant, to understand your tax liabilities and how best to structure the transactions applied.
Inheriting Real Estate
Special rules also apply for capital gains taxes if you inherit real estate or other capital assets and then sell it. Typically when someone dies, the cost basis of real estate, stocks and other capital assets he or she owns reset on the day of death. In certain circumstances, if chosen by the administrator of the estate, the cost basis resets six months after the day of death.
For an appreciating asset like a house or stock that’s performing well, that means it may be advantageous to allow your heirs to inherit the asset rather than selling the asset, paying capital gains tax and passing the net proceeds on to your heirs.
Donating Capital Assets
If you own real estate or other assets that you’d have to pay capital gains on if you sold them, and you want to make a charitable donation, it can sometimes be more advantageous to donate the assets to charity. You can often claim the fair market value of the asset, up to 30 per cent of your adjusted gross income, as a tax deduction and will avoid paying capital gains tax on the sale of the asset.
For assets, including real estate, worth $5,000 or more, you must have the assets professionally appraised to claim the deduction unless they’re cash or securities. Hold on to all records related to the donation and appraisal in case they’rethe ATO requests them. Remember that you must itemize your tax deductions to claim charitable donations.
Multiple ways are available to avoid the tax, but none are beneficial to the economy. Here are the loopholes the government’s gain tax unintentionally incentivizes.
Investors can realize losses to offset and cancel their gains for a particular year. Savvy investors harvest capital losses as they occur and then use them on current and future taxes. Up to $3,000 of excess losses not used to cancel gains can offset ordinary income. The remainder of the loss can be stored and carried forward indefinitely.
This encourages investors to sell great investment vehicles during a temporary dip only to buy them back again 30 days later for a new cost basis.
Primary residence exclusion
Individuals can exclude up to $250,000 of capital gains from the sale of their primary residence (or $500,000 for a married couple).
Families who stay in the same home for decades suffer a tax that more mobile families avoid.
Smart homeowners who might move or need the capital move more frequently to avoid the tax. Needlessly selling and buying a home is the arduous cost to the economy.
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.
If you sell rental or investment property, you can avoid capital gains and depreciation recapture taxes by rolling the proceeds of your sale into a similar type of investment within 180 days. This like-kind exchange is called a 1031 exchange after the relevant section of the tax code. Although the rules are so complex that people have jobs that consist of nothing but 1013 exchanges, no one trying to avoid paying these capital gains, tax fails. This piece of valueless paperwork does the trick.
Stock investors with highly appreciated securities can also do a like-kind exchange. Certain services offer investors with one highly appreciated security a way to trade it for an equivalently valued but more diversified portfolio. This expensive service can help investors avoid paying even larger capital gains taxes. But it is an entire field invented by government taxation. If the capital gains tax didn’t exist, all of those valuable workers and capital could be allocated to more economically beneficial means.
ETFs use stock exchanges to avoid triggering capital gains taxes when stocks move in or out of the index on which the ETF is based. Stocks moving out of the index are exchanged for stocks moving into the index. Investor cost basis transfers to the new securities.
Traditional IRA and 401k
If you are in the higher tax brackets during your working career, you can benefit from contributing to a traditional IRA or 401k. This both reduces your income while you are in the higher brackets and eliminates any capital gains as a result of trading in the account. Rebalancing by selling appreciated asset classes in a tax-deferred account avoids the capital gains tax normally associated with such trading. During the gap years, between retirement and age 70, withdrawals from these accounts could be made in the lower tax brackets.
Roth IRA and 401k
Traditional accounts can postpone taxes to a more favourable year, but Roth accounts can avoid them altogether. Having paid tax on deposits, a Roth account allows tax-free growth for the remainder of not only your life but also the lifetime of your heirs. Unless you are in the higher tax brackets and approaching the gap years, Roth accounts are usually an excellent tax strategy.
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.
The tax punishes entrepreneurship. Where the capital gains tax abolished entirely, some of the lost tax would be regained through economic expansion and more efficient and liquid capital markets. Conversely, since capital gains taxes have been raised, the slowing of economic growth could reduce tax revenue by more than the additional tax collected.
The optimum capital gains tax rate is zero. If it was zero for everyone, all these shenanigans to avoid the tax could be ignored.