Capital Gains and Real Estate
We hear a lot about “capital gains” and capital gains taxes. To some, this is a complex world fit only for CPA’s and tax attorneys. However, it is really not that bad. In this post I will go over what is and what is not a capital gain, how capital gains apply to real estate transactions, and when you don’t have to pay taxes on your capital gains.
What exactly is a capital gain? Well, let’s unpack the term “capital gain”. Capital, according to the IRS, refers to a person’s or a business’s “capital assets”. The Service defines a “capital asset” as “almost everything you own and use for personal or investment purposes”. For our purposes, then any real estate that you may own is a capital asset.
Now, let’s look at the term “gain”. In this context, a gain is the difference between the investment in a capital asset and the higher sales price of that asset as opposed to a loss that would occur if you sold a capital asset for less than your investment. This is important because the IRS divides capital transactions into two categories, capital gains and capital losses. Capital gains and losses are then divided into two additional categories, long term capital gains (or losses), and short term capital gains (or losses). If you hold an asset for more than one year before you sell it, it is a long term capital gain or loss. If you hold an asset for less than twelve months and sell it, then it is a short term capital gain or loss, as the case may be.
So why all the fuss? The fuss is about the difference between a capital gain and ordinary income. Ordinary income is income from work, interest, wages, providing services, selling inventory or earning royalties. A capital gain is profit derived from selling a capital asset and capital gains are taxed at a much lower rate than ordinary income. The highest marginal tax rate for ordinary income is 39.6%. The highest tax rate on capital gains is 20%.
Now I have some good news and some bad news. The bad news is that short term capital gains are taxed at the same rates as ordinary income. The good news is that if you sell a capital asset, like a piece of real estate at a profit, and it qualifies as a long term capital gain, that income is taxed a much lower tax rate than if you made the same amount in wages.
So, in the context of a real estate transaction, you have three possibilities:
1. Your transaction is a short term capital gain and you pay your taxes at the ordinary income tax rate.
2. Your transaction is a long term capital gain and you pay the lower capital gains rate tax.
3. You pay no taxes.
And everyone stops and says, “Wait a minute, did you say no taxes? How do I qualify for that?” First, if you earn capital gains but you are in the 10% or 15% tax bracket, some or all of your capital gains will be taxed at 0%. Second, there is a tax exclusion of earnings from the sale of your primary residence (a residence you lived in for 2 of the last 5 years) of up to $500,000.00 for a married couple. That’s right, you and your spouse can earn up to 500K tax free!
Congress is constantly tinkering with the capital gains rates, exclusions, and depreciation rules. If you are buying and selling a lot of real estate, you need a competent and qualified CPA to keep you out of trouble and paying just what you owe. Tax advice should be tailored to your individual circumstances and articles such as this are not a substitute for specific advice of a competent attorney who knows your particular situation.
Terry Adams is an attorney licensed to practice law by the Supreme Court of Tennessee, United States Tax Court, and United States District Court, Eastern District of Tennessee. Among his many published articles he is the author of The Art & Science of Negotiation; Business Law: Representing the Whole Client; and Getting it Right When it Counts – Crisis Management and Critical Decision Making. Adams is the founder and managing attorney of the Adams Law Firm and president of Admiral Title, Inc. in Knoxville. Currently he sits on the Tennessee Bar Association’s Executive Committee for Sports & Entertainment. Terry Adams focuses his practice on negotiations, contracts and business litigation. Terry has been peer reviewed as a “Top Attorney” in several categories as published in Knoxville Cityview Magazine, including in the categories of Real Estate Development & Financing Law, Business/ Commercial Law, and Sports & Entertainment Law.
TERRY ADAMS, ESQ.
The Adams Law Firm
8517 Kingston Pike
Knoxville, TN 37919
Phone: (865) 531-6440
Fax: (865) 381-1394
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