4 Misconceptions about Real Estate & Capital Gains Tax
Walking away with a profit on your home sale is an exciting proposition. But there’s one thing that can suck the excitement right out of such a positive financial move:the threat of taxes on your investment gain — otherwise known as the dreaded capital gains tax.
Luckily, the Taxpayer Relief Act of 1997 helps many homeowners hold on to the gains earned on their home sale. Pre-1997, homeowners could only use a once-in-a-lifetime tax exemption of up to $125,000 on a home sale, or they would need to roll their earnings into the purchase of another home. Today the rules aren’t quite so stringent. As with all tax-related things, there are plenty of exceptions and loopholes to be aware of. So let’s break down a few misconceptions about capital gains and home sales.
Tax treatment: House flippers vs. homeowners
One common misconception when it comes to capital gains tax on real estate is that all home sales are treated equally. Unfortunately for house flippers, that’s simply not the case. To receive the best tax treatment on your gains, you must have used the home as your primary residence for two out of the five years preceding the sale. If the home was not used as a primary residence for the required time, profit on the sale is taxed as capital gains. However, for those who flip houses on an ongoing basis, homes are considered inventory instead of capital assets, and the profit earned is taxed as income. Long-term capital gains tax is 15% for most people, 20% for those in the top tax brackets. However, if the gains are taxed as income, rates could range from 10% to 39.6% depending on the rest of your income. In addition, house flippers aren’t allowed to simply avoid the tax by rolling profits over into their next home purchase.
Exemption limits: Filing married vs. single
While the Taxpayer Relief Act did away with the once-in-a-lifetime tax exemption of $125,000, exemption limits haven’t completely fallen by the wayside. Now you can pocket up to $500,000 of each home sale profit tax-free if you’re married, or up to $250,000 if you’re single. But for some newly married couples, claiming this exemption can be a little tricky. If one person owned the house for the past two years, but their partner wasn’t added to the title until, say, the last two months, that’s OK. However, both parties must have lived in the residence for two years prior to the sale — even if only one was on the title before they were married. In addition, if one person sold a previous home within the last two years and cashed in on an exemption, the couple will have to wait until they are both out of that two-year window before pocketing any gains from their shared home.
Type of home: Primary residence vs. vacation home or rental property
If you aren’t flipping homes, but you do have a second home or a rental property you’d like to sell after living there for the required two years, it won’t be treated as a primary residence for tax purposes. Second homes and rental homes no longer receive the same tax shelter they did before a 2008 shift in the tax code — even if the home becomes your primary residence for a time. Instead, when tax time comes around, you will owe a prorated amount based on the number of years the property was rented out or used as a second home after 2008. If, for instance, you used your vacation home as your primary residence for five years starting in 2010, but you used it as a vacation home for 15 years before that, only 10% of the gains would be taxed: The two years post-2008 when it was used as a vacation home equals 10% of the total 20 years of homeownership. The rest of the profit wouldn’t be taxed as long as it fell within the exemption limits.
Profit: Large sale price vs. small sale price
Another common misconception is that the more a home sells for, the larger the tax bill will be. However, for tax purposes, what you owe doesn’t depend on the sale price — it’s based on how much profit you make from the sale. In fact, you could sell your home for $5 million and not owe a penny in taxes — as long as you didn’t make more than the allowed exemption amount on the sale.
Another important thing to note: Capital gains tax on real estate isn’t necessarily an all-or-nothing proposition. If you’re nearing the cap on exemptions, you could still qualify for a partial exemption — just be sure to consult a tax professional before you make any big moves.
The Truth About Bi-Weekly Mortgage Payment Plans
Traditionally, your mortgage payment is a monthly cost. You submit your payment once a month to the mortgage company, and your money is applied to principal, interest, and escrow. But many mortgage lenders also offer biweekly mortgage payment plans that allow you to pay in installments every two weeks instead of every month. Biweekly payment plans sound simple and straightforward: You pay biweekly instead of monthly and reduce the balance on your loan faster. In theory, by using one of these plans, you pay less interest over time, build equity faster, and get rid of your mortgage ahead of schedule.
But before you sign up for a biweekly mortgage payment plan, it’s important to understand the pitfalls — and consider whether putting this concept to work on your own makes more sense.
Should I sign up for a lender-sponsored biweekly mortgage payment plan?
Unfortunately, these mortgage payment plans don’t always work as well as they claim. What actually happens is that you send in your biweekly payment to the company servicing the loan, and then they hold your payment until the second one arrives. Only after the company has the full monthly payment amount do they apply the money to your mortgage — which means as far as the mortgage company is concerned, you’re still making one payment per month.
In effect, this saves you nothing in interest because your funds are still only being applied as if you were making monthly payments. Worse still, some biweekly mortgage payment plans can actually ending up costing you more money, because the companies that offer these plans often charge additional fees to handle and deliver the payments for you.
If they don’t help pay off a mortgage early, why do these payment plans exist?
Considering the potential costs for the borrower, it may seem silly for lenders to even offer this plan. What’s the point if using the payment plan is no different than if you paid on the regular monthly schedule? Consider this: Most lenders who originate loans don’t actually service those loans. A third party handles the payment and the processing. But that doesn’t mean you can’t make a plan to pay down your mortgage loan ahead of schedule. You just don’t need to set it up through a lender-originated plan.
How can I pay off my mortgage early on my own?
There’s nothing wrong with the idea of paying extra on your mortgage and accelerating the rate at which you pay off the loan. You can make extra payments at any time, and you can do so in a variety of ways. Consider adding a little more to each monthly payment you make to help pay off the mortgage early. If you know you have an extra $100 in your budget each month, tack that on to your payment. For example, on a $100,000 loan (assume a 30-year fixed mortgage and 4% interest), paying an extra $100 a month can cut approximately 8.5 years off the life of the loan — and save $22,463.76 in interest. That’s some serious cash.
Another option? Create your own biweekly payment plan. By skipping the third-party processing (and the fee they add on for doing so), you’ll end up making an extra payment each year that you wouldn’t make if you paid monthly. You can also continue to pay monthly but make one extra mortgage payment at some point during the year to get the same result. Anytime you have extra money on hand — from a tax return, bonus from work, or gift — you can apply these funds to your mortgage too.
Just be sure that any extra payments you make are applied to the principal of your loan, not just the interest. This ensures you’ll actually receive the full financial benefit of paying extra toward your mortgage and be on track to pay off the loan early. You’ll also want to ensure that the terms of your mortgage will not leave you with a prepayment penalty should you pay extra or early.
10 Questions to Ask Your Mortgage Lender
One of THE MOST important stages in the home-buying process is finding a reputable lender or mortgage broker to handle your transaction. A good lender will respect that you work hard for your money — and you want to spend it wisely.
After running a credit check, your lender will present you with options for what you may qualify to borrow. The mortgage amount can be different depending on two things: the product and interest rate. Since the interest rate determines what you’ll owe every month on that balance, understanding how different mortgage products work is key. Here are 10 questions to ask to make sure you’re getting the best rate (and the best deal).
- What is the interest rate?
Your lender will offer you an interest rate based on the loan and your credit. The interest rate, along with the mortgage balance and loan term, will determine your real monthly payment. A loan with a lower balance or a lower interest rate will make for a smaller monthly payment. If you’re not satisfied with the interest rates offered, work to clean up your credit so you can qualify for a lower interest rate.
- What is the monthly mortgage payment?
As you develop a budget for your new home, make sure you can afford this monthly mortgage payment — and be sure to include insurance and taxes in your monthly payment calculations. And don’t forget about short-term financial goals — say, saving up for a vacation or buying a new computer — and long-term retirement goals to consider. Your monthly mortgage payment shouldn’t be so high that your money can’t work toward your other financial goals.
- Is the mortgage fixed rate or an ARM?
Fixed-rate loans keep the same rate for the life of the loan, which can range between 10 and 30 years. Adjustable-rate mortgages, or ARMs, have interest rates that change after an initial period at regular intervals. If you don’t plan to stay in your home long-term, a hybrid ARM with an initial fixed-rate period may be a better choice, since this type of loan tends to have lower interest rates than fixed-rate mortgages.
If you do consider an ARM, make sure you ask (and understand!) when the rate will change and by how much. Ask how often the rate will change after the initial interest rate change, the index that it’s tied to, and the loan’s margin. There are usually caps to how much the interest rate can increase during one period and over the life of the loan, so recalculate the monthly payment to make sure you can afford that higher rate.
- What fees do I have to pay?
One-time fees, typically called “points,” are due at closing. For every point you pay, your lender will decrease your interest rate by 1%. You can also inquire about whether you might have the option of paying zero closing fees in exchange for a higher interest rate.
- Does the loan have any prepayment penalties?
If you’re saving up to make some extra mortgage payments to pay off your mortgage principal early, you may have to pay a fee. Don’t forget to ask this important question.
- When can I lock in the interest rate and points, and how much does this cost?
Your lender may be able to lock in your interest rate for a time, and for a fee. If rates go up, you’ll still be able to benefit from a lower rate on your mortgage.
- What are the qualifying guidelines for this loan?
The underwriting guidelines are different for every loan, as are income and reserve requirements. Along with requiring you to have sufficient funds for the down payment and closing costs, most mortgages require proof of income and reserves of up to six months of mortgage payments.
- What is the minimum down payment required for this loan?
Different loan products have different down payment requirements. Most mortgages require a 20% down payment, but if you qualify for an FHA loan, for example, your down payment could be as low as 3.5%. In general, loans with lower down payments cost more.
- Do I have to pay for mortgage insurance, and how much will this cost?
Putting down less than 20% on your purchase requires paying mortgage insurance until your loan-to-value, or LTV, ratio falls below 80%. Mortgage insurance premiums can be expensive, sometimes costing up to $100 per month for every $100,000 borrowed.
- Do you have other mortgage products with lower rates that I qualify for?
The best way to comparison-shop is to start with your current lender. They probably offer more than one type of loan, and these may have terms better suited to your financial situation.
Will a New Bill in Congress Help You Qualify for a Mortgage?
A new bill in Congress could significantly impact your ability to secure a mortgage by changing the way lenders look at credit scores.
Known as the Credit Score Competition Act, the bill is in its first stage of the legislative process. Although it’s a long way from becoming a law, future homebuyers have good reason to keep an eye on this bill. The bill would push for a new credit-scoring system, one that could potentially allow more buyers to secure funding. This is a big deal for those who have a low FICO credit score but are otherwise good home-loan candidates.
People with credit scores that do not meet FICO’s standards of “good” or “excellent” could be evaluated under different credit-score systems and therefore have their credit rated differently. In theory, this could help those buyers receive approval for a mortgage they might otherwise have missed out on. Because Fannie Mae and Freddie Mac own about 90% of the secondary mortgage market, and they’re allowed to consider only FICO scores, there’s no room for competition in the credit-scoring industry.
With such low competition, there’s no reason for companies to innovate.
This matters because not everyone has access to traditional forms of credit that beef up your FICO credit score (think steady income, bank accounts, assets, and months of credit-building history). Proponents who argue Fannie Mae and Freddie Mac should be allowed to look at new credit-scoring systems say FICO’s way of formulating credit scores is unfair to a number of groups, including first-time homebuyers, lower-income families, and minorities. The model currently used to score borrowers is based on data from nearly 20 years ago and excludes millions of people that companies like Experian say are creditworthy but whose scores don’t reflect that under the system in place today.
Credit-scoring models currently used in the residential mortgage process judge someone’s creditworthiness on a strict set of criteria but leave out factors that may indicate financial responsibility. For example, right now, FICO generally doesn’t take into account factors such as whether you pay your rent on time. Sometimes, that’s the only way first-time homebuyers can demonstrate they’re capable of handling a monthly mortgage payment. The current credit-scoring model also effectively punishes borrowers who don’t have much of a credit history; a short or nonexistent credit history can drag down overall scores. With this system, if you’re financially responsible, a diligent saver, and debt-free, you could still miss out on a mortgage because you don’t utilize credit in your day-to-day life.
Stay tuned to Credit Score Competition Act's journey through the legislative process!
Should You Combine Finances with Your Partner?
Depending on who you ask, combining finances with your significant other is either a positive step towards establishing a life together OR the worst idea ever. If you're considering it, here are some pros and cons to weigh.
Pros
Teamwork
If you’re on the same page and your financial priorities are fully aligned, you're likely looking beyond your own personal needs and wants and putting the needs of the relationship first. By combining all your assets and liabilities, you’re ultimately making the commitment to succeed or fail together, as a unit.
Simplicity
One of the benefits of joining accounts is that it makes bill paying and record keeping a whole lot easier (particularly if you’ve established a budget).
Furthermore, combining your loan accounts, such as credit cards, could help you get additional loans in the future.
And if you’re making consistent, timely payments, both of your credit scores will improve. If you had kept that credit account separate, only one of you would have the benefit of a higher score, which could hurt you down the road when you apply for additional credit.
Taxes
Sure, filing separate returns may be beneficial in some instances. (For example, if one spouse has large medical bills and can meet the deduction threshold by considering only his or her income.)
But joint filing saves time, and possibly money, too — particularly if you both work and one of you makes considerably more than the other. Combining incomes could bring the higher earnings into a lower tax bracket.
Also, some tax credits are only available to a married couple when they file jointly. Talk to your accountant for additional information about minimizing the tax bite.
Cons
Attitudes
Some couples may not agree on certain issues, like creating a spending/saving plan, setting retirement goals, or even how much debt they should carry. After all, opposites do attract, and in many relationships, there is, in fact, a spender and a saver.
If your financial philosophies don’t align, and you’re combining your financial life with someone who has vastly different expectations, goals, systems, ideals and habits, this could bring challenges and unwelcome relationship conflict.
Dependence
If you’ve been managing your money on your own for years, and have been relatively successful in doing so (from choosing your 401K funds to setting a budget to planning a vacation), you may not want to relinquish your financial autonomy.
Sure, there may be more bookkeeping for you to do if you keep your finances separate, and opt for more of a yours/mine/ours account type arrangement (commonly referred to as the “three pot system”), but it may ultimately provide you with the independence and comfort you desire.
Disentangling
You may be in la la land now, but what happens if the relationship doesn’t work out in the long run? Joint mortgages, credit cards, and bank accounts can be very difficult to separate, even with a formal court-ordered divorce decree.
4 Financial Benefits to Buying a Home
Mortgage rates are still at historic lows, and there's no denying that now is a great time to purchase a home. Here are four reasons why it makes a lot of financial sense.
1) Homeownership Builds Wealth Over Time
Most of us were taught growing up that owning a home is financially savvy. Although that confidence was shaken during the economical turbulence of recent years, real estate is still proving to be a great long-term investment.
2) You Build Equity Every Month
Your equity in your home is the amount of money you can sell it for minus what you still owe on it. Every month you make a mortgage payment, and every month a portion of what you pay reduces the amount you owe. That reduction of your mortgage every month increases your equity.
3) A Mortgage is Like a Forced Savings Plan
Paying that mortgage every month and reducing the amount of your principal is like a forced savings plan. Each month you are building up more valuable equity in your home. In a sense, you are being forced to save and that's a good thing.
4) Long Term, Renting is Cheaper Than Buying
In the first years it may be cheaper to rent. But over time as the interest portion of your mortgage payment decreases, the interest that you pay will eventually be lower than the rent you would have been paying. But more important, you are not throwing away all that money on rent. You have to live somewhere, so instead of paying off your landlord's home or building, you're paying off your own!