Understanding Capital Gain and Tax Exclusions

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The understanding of capital gain comes after comprehension of tax basis. According to the Certified Mortgage Planning Specialist (CMPS) Institute, tax basis is the cost of buying, building, and/or improving a property. For example, you purchase a $150,000 property with $5,000 in closing cost. Then you spent $35,000 improving the property ($150,000+ $5,000+ $35,000= $190,000). At the end of that process, it cost you $190,000 to buy and improve that property which is your tax basis.

Moving forward, assume that you then sell that same property for $380,000, incurring $38,000 in sales commissions, transfer taxes, and other sales expenses. To calculate your capital gains, you would subtract your tax basis from your sold price including your additional fees ($380,00- $38,000-$190,000= $152,00), totaling to $152,000. Capital gains tax rate is currently at 15% for most taxpayers, meaning your capital gains tax would be about $22,800 (.15x $152,000= $22,800).

3.8% net investment income tax was added by the federal government, in 2013, to help pay for changes to Medicare. This tax applied to single taxpayers who earn more than $200,000 and married taxpayers making more than $250,000.

There are exclusions to this tax, though. If this property is your primary residence, then you can qualify for what is called a principal residence exclusion. This exclusion means that a certain portion of the capital gain is excluded from taxes. That portion is up to $500,000 for married couples and $250,000 for single taxpayers, or married filing separately. Meaning, in the example above, the entire $152,000 would be excluded, saving you at least $22,800 in capital gain taxes.

In order to qualify for this exclusion, one must live in the home for 2 out of the last 5 years. Additionally, you can only use the exclusions, once every 2 years. If the property has a large capital gain, then it might be wise to consider selling and doing the process over again on another property. There is not a limit on how many times you can use the exclusion if you follow the other criteria.

Furthermore, this exclusion does not apply to vacation homes or investment properties, including limitations on this exclusion when turning rental property into primary residence and vice versa. If you rent out the house before you live there, then you can only calculate how much gain you exclude based on what percentage of the time you resided in the home. If you rent the home for 2 years and lived in it for the next 2 years, then you can only exclude 50% for the time you were the primary resident. However, if you choose to rent the home out, after living in it, these additional calculations do not apply to you.

If you are looking to explore investing and capital gains, reach out to the professionals at Crown Realty Experts who would love to help walk you through this process.