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.
6 Ways to Buy a Home Even if You Think You Can’t
There are many obstacles when buying your first home. It takes diligent work, and to say the least it is expensive. Especially when you consider the rise of real estate and interest rates. Here are six issues that I am sure you have heard will get in your way. However, I have good news for you, there are ways around them.
- The big 20% down payment
The standard in buying a home is 20 percent money down, which means a lump sum of 20% of the purchase price paid upfront. On a 300,000 house, the down payment would be at $60,000, which is definitely not pocket change. Putting down 20% will allow you to have a lower mortgage and monthly payments. However, according to the National Association of Realtors, 81 percent of Americans purchased their first home with less than 20 percent down to as little as 3 percent. Here are some alternative options to come up with a down payment that would get you near the 20% percent mark. One option is to go to your family and ask for a gift. You can get up to $14,000 tax-free money from your mom, dad, and even your grandparents. If all 4 of them decide to bless you with a gift, that is $56,000 tax free money that can go towards your down payment.
Another option that many people take advantage of is borrowing against their 401(k) or IRA. You are able to borrow up to $50,000, or 50% percent of your plan. First time homebuyers may qualify to take up to $10,000 from their IRA without having to pay early withdrawal penalties.
Now let’s say with all of that, you still don’t have enough money. If you have always dreamt of having a big lavish wedding as a child, you can always skip out on asking for that fancy blender and new 70-inch TV, and request money from your guests instead.
Another possibility is to completely skip on having the big wedding in general, and maybe opt to have something smaller and more intimate. This will surely save you a lot of money that you could be putting down on your first home.
- Bad Credit
This might be the biggest obstacle of all when buying a home. The lower a credit score, the higher the interest will be or you might not even qualify at all. The best thing to do is to clean up your credit as much as possible, pay your bills on time, and consult with a mortgage broker for suggestions on how to improve your score. A few things that a mortgage broker will tell you is to not incur more debt. Hold back on purchasing a new car and completely avoid opening up new lines of credit. Lastly, know your credit score inside and out. According to the National Foundation of Credit Counseling, 42% percent of Americans have not checked their credit score in at least 12 months. The two most important credit scores you need to know are 620 for the Federal Housing Administration for your insured loan, and 720 for a conventional loan.
- Knowing your price range.
A standard rule to determine your first homes price range is to figure out how much you can afford each month. Lenders say your PITI (principal, interest, taxes, and insurance) should not be more that 28% percent of your income before taxes. Some banks will go up to 33% percent which means if you earn $5,000 per month, the maximum PITI payment the lender will allow is $1,650 a month. Banks are looking for your back-end ratio; the sum of your PITI payment and all revolving debit (credit cards, car loans, all other loans you carry), which should be no higher than 41% to 50% percent of your gross monthly income.
- Fear of a bad loan
For many years a 30-year mortgage with a fixed interest rate was the only option. In recent years the industry has changed exponentially and developed new programs to help more people become homeowners. Some loans begin with a low interest rate and adjust upward by a certain percentage about every year. Many people choose to go with a low interest rates at the beginning of the loan and sell the house for income before the loan adjusts. Consult with your mortgage broker to find out what will be the best for you.
- Where to begin
Some first-time buyers think spending hours on Zillow and going to every open house is the best way to start; but its not. The best way to begin is to get educated. Fannie Mae and Freddie Mac both offer classes and a lot of information on their website that can support you through the process.
Some basics:
Real estate brokers work on a commission base, typically around 6% percent. There is no need to pay any fees upfront to an agent for them to help you walk into a house to check it out. If and when the property is sold they will get paid.
A house on the market for a long time does not necessarily mean it has any serious flaws. The seller may have an unrealistic expectation of the value of their home, or it could be something else. Don’t be afraid to offer lower and let your agent negotiate on your behalf.
You will see that every home will come with some type of issue large or small.
Unless you’re buying a brand new home, you should expect some fixing up to do. Now it’s up to you to decide the extra costs are worth buying the home.
- The offer is made and now I’m scared
You found the home of your dreams and you make your offer. This offer should come with at least two contingencies. 1. You’ve had the chance to have a private professional inspector come out and look at the property. If the inspector finds issues that are out of your budget to fix, you can always negotiate the purchase price or walk away. 2. Your offer is based on the ability to pay for the property. If for some reason you are not able to pay then you can simply walk away. After all negotiating is said and done, you and the seller will go into a process called escrow. That is where a third party will make sure all of the legalities are in excellence before completing the sale. Escrow will handle the money components, and seal the deal between you and the seller. Congratulations, you are now a first time homeowner!
Now that you know what it really takes to achieve the American Dream of homeownership, give us a call and we'll walk you through the process in no time! 702-331-8185