Before getting started with ways to reduce capital gains tax, let’s chat about how the capital gains tax works for your primary residence. Currently, you do not pay capital gains tax on gains of $250,000 or less if filing single and $500,000 or less if filing married filing jointly on your tax return. Here are the rules to receive the capital gains tax exclusion on your tax return in the year of sale:
1. You must live in the home as your primary residence for 2 out of the last 5 years.
2. You can take the exclusion once every two years.
3. You don’t have to use the proceeds to buy another home.
4. The exclusion only applies to primary homes and not rental properties.
5. Special rules if you convert a rental property into a primary residence.
The exclusion seems high right now! So why worry about capital gains tax on a primary residence? Well, as with any current tax law, it can be changed at any time…. With the rate that the government is spending money these days, what are the chances that exclusion amount is going down? That’s what I thought….
Now let’s briefly address capital gains tax on rental properties. The rules are simple. If you are not doing a 1031 exchange or investing in an opportunity fund, both as defined by the IRS, you are paying capital gains tax on rental properties at the time of sale. There is NO exclusion amount for capital gains tax on rental properties.
The question is how much capital gains taxes you will need to pay on the sale of a rental property. Even if using 1031 exchanges, at some point, down the road, you will be paying capital gains taxes. Capital gains tax rates are historically low right now, but again, what are the chances those rates will stay low?
One more item to clarify before talking about ways to reduce capital gains tax on real estate. There is a difference between real estate expenses that increase the cost of the home and those expenses that do not. Accounting guidance states if the real estate expense results in an increase in the value of your home or increases the useful life of your home, then you can increase the cost of your home by the expenses paid. Think bathroom or kitchen remodel, replacing carpet with real hardwood floors, replacing the entire roof on the home, to name a few.
As for those items that do not increase the cost of your home, think of roof repairs rather than replacement, planting seasonal flowers, replacing a refrigerator (not part of a kitchen remodel project, that is), replacing carpet with carpet, and the list goes on and on…. The good news is that you can take a deduction for real estate expenses for rental properties that do not increase the cost of the home. Not true for primary residences, though.
Let’s go back to real estate expenses that increase the cost of the home. Accumulate those costs over the years of ownership and be sure to maintain proper records as backup for those costs. The more you can increase the cost of your home, the less in capital gains tax you will have to pay at the time you sell your home. Easy enough, right? Don’t forget - the government can reduce the capital gains exclusion on primary residences and/or increase capital gains tax rates at any time. If that happens, ensure that you are not paying more in capital gains tax than you should be paying by keeping records of any improvements on your home.
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