In real estate, capital gains are the difference between the purchase price of your real estate and the price you sell it for. Capital gains tax is what you pay on that difference, after adjusting for a variety of exemptions, deductions and tax breaks.
The tax on capital gains income is calculated separately from the tax on your regular income and often at a different rate. In addition to federal capital gains taxes, most states, including California, tax the gains too.
In most instances, the real estate exemption rules are as follows:
- If you are single, you can make up to $250,000 in profits on your home sale before you have to pay taxes.
- If you are married, you can make up to $500,000 in profits before paying capital gains tax.
To qualify for the exemption, you have to meet all of the requirements:
Must be your principal residence
This tax break is designed for people who are selling the home they live in, not investment property. You have to live in this residence for two out of the last five years. There are no limits on how many times you can use this as long as you meet the two-year requirement. As far as living in the home for two out of the last five years, there are no hard and fast rules regarding this situation. You could have lived in the home the first year; rented it the next three, and lived in it again in the last year and you would be fine as far as the capital gains exclusion goes.
This does not apply to your vacation home
Remember that selling a second home does not yield the same tax benefits. Even if you move into the second home and live there for two years, some of the profit from the sale will still be taxable, based on how long the residence was used as a secondary home.
Understand your new spouse’s home sale history
Although the law is fairly lenient on residency times for marriages, it is not so lenient on previous uses of the exclusion. If your new spouse used the home sale exclusion within the past two years – like selling his own house to move in with you – this will impact your ability to use it for the current home sale. If he just sold the house, you will need to wait a full two years before you can take advantage of the full exclusion. You may be able to get a partial exclusion though, depending on your situation.
Special Provisions for Extenuating Circumstances
The military tax exclusion
Being in the military has its benefits when it comes to capital gains and selling a home. Because of being deployed, those in the military often find it hard to meet the residency rules and end up paying taxes when they sell. A law put in place in 2003 exempts military personnel from the two-year use requirement mentioned above for up to 10 years, letting a service man or woman qualify for the full exclusion whenever they must move to fulfill their service commitments. There are also additional tax benefits for being a veteran that should be understood.
Your spouse passes away
Another provision in the tax law was changed in 2008. This change takes into account the special circumstance an owner faces after their spouse dies. Previously in order to exclude the full profit amount excluded from taxes the surviving spouse had to sell within the same year of the death. The change allowed the widower to have up to two years to sell the property without facing the burden of paying taxes. As long as the surviving spouse sells within the two years window they will be able to exclude the full amount of profit.
Important: Use Trusted Professionals for Advice
It is very important to get the advice of trusted professionals (tax attorneys, real estate agents, financial planners, etc.) to answer questions and provide guidance.
If you have any questions about real estate please give me a call and I can provide a listing of resources for you to contact to get further information and help.