Probably the largest concern that arises when someone wants to sell property is the possible tax implications of such sale. Luckily, the tax code is set up in such way that incentivizes property ownership and transfer. This means that there are procedures by which tax can be avoided that have been built into the tax code. We will explore some of those procedures, but first we will lay some foundation.
Types of Tax
There are many types of tax (e.g. excise tax, estate tax, etc.). The type of tax you’re likely most familiar with is income tax. The tax that this article is most concerned about is capital gains tax. Similar to income tax, the amount of capital gains tax you may incur is based on the amount of gross income you earn each year. Such rates can be found at IRS.gov, specifically look at Tax Topic No. 409 Capital Gains and Losses.
Capital Gains Tax
So, what is capital gains tax? Capital gains tax (or cap gains for short) is the tax you incur as a result of selling a capital asset. A capital asset is most anything you own: your house, your car, your toothbrush. The best way to think about capital assets is that everything you own is a capital asset—unless it isn’t. An example of things that aren’t capital assets are patents or copyrights, accounts receivable, and inventory held in a trade or business. Refer to 26 U.S. Code § 1221 for the exact definition.
Calculating Capital Gains Tax
To calculate the amount of capital gains tax you owe on the sale of a capital asset, you must first determine your basis and your gain.
The best way to think of basis is that it’s the baseline value you’ve invested in the asset. There are many ways to establish basis; however, we will discuss the most intuitive method: cost basis. Cost basis is equal to what you pay for an asset. So, if you buy a car for $25,000, your basis in that car is $25,000. Cost basis can increase with further investment. Let’s say you decided to put some after-market parts on the car worth $5,000, your basis in the car is now $30,000.
Your gain, if any, occurs when the asset is sold. The gain is equal to the difference in the basis and the sales price. For example, if I pay $25,000 for a car, my basis is $25,000. If I then sell that car for $30,000, I have a gain of $5,000 ($30,000 – $25,000 = $5,000). In much the same way, if you sell the car for less than your basis, you have a loss equal to the difference in your basis and the sales price.
After you’ve found your gain, you will then apply the applicable capital gains rate to your gain. For example, let’s say your gain is $5,000 and, based on your annual gross income, your rate is 15%, your capital gains tax will be $750 ($5,000 x 15%).
Avoiding Capital Gains Tax
Procedure 1: Sale of Personal Residence IRC §121
The largest capital asset for most of is our home. Real estate tends to appreciate in value, which is a good thing if you own a home. However, when you go to sell that home, you don’t want the appreciation in your home’s value to lead to a giant tax bill. Thankfully, there is a provision in the tax code that allows you to exclude a certain amount of gain from the sale of a personal residence (see IRS Publication 523).
Per section 121 of the Internal Revenue Code, you can exclude up to $250,000 worth of gain from the sale of a personal residence if you’re a single individual and $500,000 if you’re a couple. To qualify for this exclusion, you must have owned and resided at the property for 2 out of the last 5 years leading up to the sale.
Procedure 2: Like-Kind Exchange IRC §1031
In the past, section 1031 applied to many types of assets. Since 2017, and the adoption of the Tax Cuts and Jobs Act, a like-kind exchange can only be done with real property. A like-kind exchange (or 1031 exchange) is essentially a way to defer taxation on the sale of a piece of real property.
Let’s say that you own a rental home that you purchased for $100,000 in the year 2000. Over the last 20 years, the property has appreciated to $250,000. The rent from the property is not what you want, so you decide to sell the property and trade up. However, it’s an investment property, so you can’t use the personal residence exclusion mentioned above. If you sold the property, you’re looking at a $150,000 gain. If your capital gains rate is 20%, your tax would be $30,000. You definitely don’t want that.
You can avoid this tax altogether by rolling the gain into another piece of real property. When you roll the gain into the new property, you won’t have to pay the tax on your gain until the sale of the new property—unless of course you use another like-kind exchange.
A like-kind exchange can be done in an unlimited amount and frequency. Although, just like any good tax planning tool, it has its rules. The rules boil down to this: you must identify the new piece of real estate into which you’re planning on rolling the gain within 45 days of the sale of your property. This designation must be done in writing. Then, you must close on that new property within 180 days of the sale of your old property. Note, you can also back into a like-kind exchange if you’ve already sold property and purchased new property.
Don’t let the fear of taxes keep you from investing in real estate or selling your real property. Real property is too good of an asset to be deterred by taxes. After all, it’s the one thing they’re not making more of.
If you have question about tax planning or planning in general, give the experienced attorneys at McIntyre Elder Law a call at (704) 259-7040.
Brenton S. Begley
Elder Law Attorney
McIntyre Elder Law
“We help seniors maintain their lifestyle and preserve their legacies.”