Whether you’re selling an investment property, a home you inherited, or a home you’ve lived in when it’s time to upgrade, the goal is typically the same: you want to get as much money as you can from the sale of your home.
It may feel great to close on a high offer and get close to (or even right at) the amount you were asking for your home, but rarely will a homeowner get to keep all that money from the sale of a home.
I’m not talking about paying out commissions and closing costs, either.
The IRS may want to get a piece of the profit you made from selling your home. The tax that’s sometimes applied to your earnings from the sale of the property is called Capital Gains tax, and it can take a chunk out of the money you’ve earned.
What is capital gains tax?
According to Investopedia, capital gains tax is defined as:
“Capital gains tax is a tax levied on capital gains, which are profits from the sale of specific types of assets, including stocks, bonds, precious metals and real estate. This tax is calculated on the profit – or positive difference – between the sale price and the original purchase price of the asset.”
How capital gains taxes work
Capital gains taxes aren’t paid on a regular cycle, such as quarterly or annual taxes. Instead, capital gains taxes are only triggered when an asset (like your home) is sold. So, taxes of this nature are never paid while you hold a property, whether it’s an investment property or your own residence.
No matter how long the property or investment is held, and no matter how the property appreciates over time, capital gains taxes would not be owed until it’s sold.
How do capital gains tax work in Oklahoma?
The Oklahoma tax code provides for a capital gains tax on real property and personal property. Capital gains tax is calculated based on the gain after subtracting the original cost. Under capital gains tax, the taxable amount must be determined by considering three factors: (1) costs of acquisition, improvement, and production; (2) sales price or capitalized value; and (3) use of the property.
The tax is computed by applying a capital gains tax rate to the taxable amount.
Taxable Amount Less Than $1,000 : Tax Liability = 0%
Taxable Amount is Greater Than or Equal to $1,000: Tax Liability = 75% of the lesser of (A) The amount over $1,000 or (B) The gain.
The above capital gains tax rates are subject to a surtax calculated using the following:
Taxable Amount Greater Than or Equal to $500,000: Tax Liability = 100% of the amount over $500,000.
The above capital gains tax rates and surtaxes are all subject to a 4½ per cent surcharge on Oklahoma net income due under Internal Revenue Code section 3111 (e)(1). This surcharge does not apply to C corporations, estates or trusts.
The capital gains tax is due monthly on or before the last day of each month after the taxable year in which the sale occurred, even if a return was not required for that period because of net operating loss carrybacks. In addition, a taxpayer may be required by the Oklahoma Tax Commission to file a return even though no tax is due. The capital gains tax rates and surtaxes are effective for all taxable years beginning on or after January 1, 1970, with respect to the above dates; however, only returns due after December 31, 1984, will be subject to the 4½ per cent surcharge.
The taxpayer can elect, under certain circumstances, to defer the tax. When a taxpayer chooses to defer the capital gains tax on real property, it is treated as deferred payment of principal rather than interest. Under this election, the gain (exclusive of costs and expenses) realized from the disposition of an investment in real property is subject to capital gains tax at a rate of zero per cent. However, if the gain realized from disposition exceeds the original cost of the real property, an additional capital gains tax is due on that excess based on the rate applicable to deferred payments.
Exclusions for capital gains
The IRS does allow for exclusions when calculating capital gains.
- Single people can exclude $250,000 of capital gains on real estate sales
- Married couples (filing joint) can exclude $500,000 of capital gains on real estate sales
For example, If you purchase a home for $150,000 ten years ago and then you sell it for 600,000, you stand to make a substantial profit of $475,000 on the home. For a single person, $250k of that capital gain might not be subject to taxes, but $225k may still be. For a married couple filing joint, the full amount might be excluded.
Filing status doesn’t guarantee the exclusion
There’s no guarantee that you’ll get exclusions based on your marriage and filing status. There are a number of factors that can nullify these exclusions, including:
- The home you’re selling wasn’t your principle residence (you didn’t live there most of the time)
- You owned the property for under 2 years in the 5 year period before selling it
- Not living in the house for at least 2 years in the 5-year period before you sold the home
- You already claimed the exclusion on another home in the 2-year period before the sale of the home you’re trying to claim an exclusion on
- The home was “purchased” (acquired through a like-kind exchange) using a 1031 exchange within the last 5 years
- You’re required to pay an expatriate tax
How to avoid capital gains taxes
When looking at the factors that can eliminate your exclusion from capital gains, it’s easy to see where the tax code offers generous provisions and a huge tax break for those who are selling their house.
In order to be eligible for the tax break, you just need to make sure the home you’re trying to sell has been your primary residence, that you’ve owned it for at least 2 years, and you must have been living in the house for at least 2 years of the last 5 years.
Unless you’re dealing with high-value real estate, the exclusion is substantial and makes it so that most single people and especially married couples selling a home, are able to avoid any kind of capital gains tax.
The provisions are so substantial that a lot of real estate investors, including those who flip homes, have become adept at working the system in a way to ensure they earn tax-free income.
The key point to pay attention to is that you must live in the house for at least 2 years in order to avoid a capital gains tax. In fact, the two years don’t even need to be consecutive as long as you meet the duration.
This has provided a break to many people ranging from military to foreign services, intelligence operators, and even the disabled.
While most homeowners selling their residence don’t have to worry about this and are generally guaranteed to get the exclusion, this kind of tax can create issues with family estates.
When a family inherits property like a home, the value of the house gets a “stepped up” status. From the US Tax Code:
“Under Internal Revenue Code § 1014(a), when a person (the beneficiary) receives an asset from a giver (the benefactor) after the benefactor dies, the asset often receives a stepped-up basis, which is its market value at the time the benefactor dies. A stepped-up basis is often much higher than the before-death cost basis, which is primarily the benefactor’s purchase price for the asset. Because taxable capital-gain income is the selling price minus the basis, a high stepped-up basis can greatly reduce the beneficiary’s taxable capital-gain income when the beneficiary sells the inherited asset.”
If you’re in a position where you’ll be inheriting a home, this can benefit you as the new property owner. Even if the home isn’t your primary residence and you have not lived there, you may not have to pay capital gains taxes.
For example, a home you inherit has its value stepped up to $180,000. While the original purchase price of the home was only $90,000 and the home sells for the stepped-up value of $180,000, you won’t have to pay capital gains taxes. In this case, the tax is based on the difference between the sale price and the stepped-up value as opposed to the original purchase price vs the sale price.
Homeowners can also reduce the capital gains tax by keeping track of home improvements.
Improvements are a natural part of owning a home as well as preparing it for sale. Even those who want to sell a home fast, such as those that come from inheritance, can be faced with necessary home improvements and upgrades before a home can be sold – such as updates to get a home up to code.
Any money you spend on home improvements, especially those that are costly (think replacing plumbing, foundation fixes, repairing or replacing the roof, flooring, etc.), can all be used to reduce capital gains tax.
Specifically, because the cost of those improvements gets added to the property’s basis (the original cost of the property, adjusted for factors such as depreciation).
For example, if you performed $20,000 in updates and renovations on your home before selling it, you would have a lower gain on the sale of the home, and as such, you would potentially have a lower capital gains tax – or none at all depending on your exclusion and the final sale price of the home.
Avoiding and reducing capital gains
Depending on the reason for selling your home, you may be able to reduce and even eliminate capital gains taxes. You don’t necessarily have to go through the process of costly and time-consuming updates to your home just to adjust the property’s basis. It’s even possible to reduce and avoid capital gains tax when you need to sell your home fast.