What is Capital Gains Tax?
I recently had a client ask me about Capital Gains Tax. What is it? And how does it apply to the Home Owner? I found some great information I thought I'd share to give you, the reader, the clearest picture possible.
The federal Capital gains tax on real estate originated in 1913. Until 1921, capital gains were taxed as a form of income, at a maximum rate of 7 percent. After 1921, capital gains were classified separately from traditional income, and the rate increased to 12.5%. Congress also introduced the concept of taxing gains based on the amount of time an individual held onto the property. Depending on the number of years an individual possessed a property, he could pay a lower amount of capital gains taxes. In general, the longer a property is held, the lower the tax rate will be when the property is eventually sold.
Over the years, the federal rate has fluctuated and is calculated differently depending on the tax bracket of the individual, whether the real estate is an investment property or a main property, and finally, when and how the property is sold or transferred. President George W. Bush’s 2001 tax cuts reduced the capital gains rate to 15%. Each state has its own individual capital gains rate, which vary widely from zero percent to nearly 10%.
Main Property vs. Investment Property
To qualify as a main property, the piece of real estate must be occupied by the owners at least 24 months out of a five year period. By residing in the property, owners can deduct $250,000 individually and up to $500,000 as a married couple on their taxes if they choose to sell the property. If the owner does not reside in the property for this amount of time, they do not qualify for the deduction, unless the homeowner experiences “unforeseen circumstances” as defined by the I.R.S. These circumstances include divorce or legal separation, condemnation or involuntary seizure of the property, death, a change in unemployment status that makes payment of the mortgage impossible, damage to the property due to an act of terrorism, or multiple births resulting from one pregnancy. Owners may choose to rent out the property for the periods of time they are not residing in the unit, and still claim the property as a primary residence.
An investment property has fewer tax exemptions, and a much higher tax rate. Again, this tax rate is based on the income bracket of the investor, and whether or not he is married. Unlike the main property residence exemption, the owner may not take sizable deductions on an investment property unless he converts it to a main residence. However, if an owner improves the property, ‘depreciation recapture’ allows an owner to deduct up to 25% of the costs of the improvements from the capital gains taxes.
Other Exceptions
There are several methods of delaying, reducing, or negating the need to pay capital gains tax on both investment properties and main properties. The most popular is the 1031 exchange, which allows an owner to sell his property and reinvest the money from the sale into another property without paying any taxes. A 1031 exchange can be performed without limit within an investor’s lifetime. Additionally, if a property is passed on as part of an inheritance, the heirs do not have to pay capital gains on that property. Finally, never selling the property also allows an investor to avoid paying capital gains taxes.
| 2003 - 2012 | 2013 - | ||||||
|---|---|---|---|---|---|---|---|
| 2003 - 2007 | 2008 - 2012 | 2013 - | |||||
| Ordinary Income Tax Rate | Short-term Capital Gains Tax Rate | Long-term Capital Gains Tax Rate | Short-term Capital Gains Tax Rate | Long-term Capital Gains Tax Rate | Ordinary Income Tax Rate | Short-term Capital Gains Tax Rate | Long-term Capital Gains Tax Rate |
| 10% | 10% | 5% | 10% | 0% | 15% | 15% | 10% |
| 15% | 15% | 5% | 15% | 0% | |||
| 25% | 25% | 15% | 25% | 15% | 28% | 28% | 20% |
| 28% | 28% | 15% | 28% | 15% | 31% | 31% | 20% |
| 33% | 33% | 15% | 33% | 15% | 36% | 36% | 20% |
| 35% | 35% | 15% | 35% | 15% | 39.6% | 39.6% | 20% |
When the taxable gain or loss resulting from the sale of an asset is calculated, its cost basis is used rather than its actual purchase price. The cost basis is an adjustment of the purchase price that takes into account factors such as fees paid (brokerage fees, certain legal fees, sales fees), taxes paid (including sales tax, excise taxes, real estate taxes, etc.), and depreciation.
The United States is unlike other countries in that its citizens are subject to U.S. tax regardless of where in the world they reside. U.S. citizens therefore find it difficult to take advantage of personal tax havens. U.S. law requires reporting of income from those accounts and failure to do so constitutes tax evasion.
SOURCE: WIKIPEDIA
