Selling or buying a house can be very stressful as there are lots of documents you have to present and sign. There’s a lot of running around and meetings with your agents. You’ll be watching to see if you will gain from the sale, and you would also be thinking of how to avoid paying capital gains tax.
According to IRS, you can avoid capital gain tax by buying another house through the use of a 1301 tax-deferred exchange which should be declared at the beginning of the sale. The money made from the house sale should be given to a third party to hold until you buy another house, else you’ll pay capital gains tax.
However, it is important to note that if you want to avoid capital gains tax by buying another house through a 1301 exchange, there are rules you have to strictly follow. The rules are discussed later in this article.
What is Capital Gains Tax?
Capital gains tax is the federal fee you pay on the profit you make from the sales of properties and investment. These include stocks, bonds, real estate, etc.
Not all countries imposed this tax on those assets. While countries like Barbados, Jamaica, and Sri Lanka don’t impose this tax, countries like the USA and UK impose this tax.
The fee is not general; it depends on each jurisdiction. To get the capital gain, you will have to subtract the cost price of the asset from the sales price.
The tax rate is dependent on the profit you make and on your income annually. There is a limit to the profit you can make from the sale of the assets. If your gains exceed the limit, you’ll have to pay the tax.
In the UK, the capital gains tax is 10% of the profit if your annual income is £50,000 and below. But if you earn more than £50,000 annually, the capital gains tax is 20% of the profit. There is also an extra 8% that will be added if the asset is a residential home.
Capital gains tax can either be long-term capital gains or short-term capital gains. The short-term capital gain is always higher than the long-term capital gains.
The short-term capital gains are paid from the profit made from assets that were held for a year or lesser while the long-term capital gains will be paid on assets that were held for more than a year. This is why investors prefer to hold assets for more than a year to reduce the tax. Capital losses can also be deducted from the gains.
As of 2021 in the US, the tax rate differs based on your marital status and income. Below is the list of the tax rates for long-term capital gains.
Singles Tax Rates in the US
- Singles earning from $40,400 and below will have their profit tax free
- Those who earn from $40,401 to $445,850 will pay 15% of the capital gains as the capital gains tax
- Those who earn above $445,850 will pay 20% of the profit as the tax.
Married Filing Jointly Tax Rates in the US
- Married couples that are filing jointly will have their profit tax-free if they earn from $80,800 below.
- Those that earn from $80,801 to $501,600 will pay 15% of the capital gains.
- Couples that earn more than $501,600 will pay 20% of the capital gains as tax.
- This rule also applies to a surviving spouse
Married Filing Separately Tax Rates in the US
- Married couples that are filing separately will have their profit tax-free if they earn $40,400 below.
- Those that earn from $40,401 to $250,800 individually will pay 15% of the capital gains.
- Those who earn above $250,800 will pay 20% of the capital gains.
Gains gotten from jewelry, stamp collections, and other collectibles are taxed at a 28% rate irrespective of your income.
Also, to sell a house owned by the house owner, the excluded amount from the profit is $250,000 for an individual and $500,000 for married couples filing jointly.
Capital losses can’t be deducted from the gains. But the cost of improvement can be added to the cost to reduce the amount to be taxed. There are various ways to avoid the capital gains tax.
Can You Avoid Capital Gains Tax by Buying Another House?
If you are into real estate investment, you can actually escape capital gains tax by buying another house. It will be as a 1301 tax-deferred exchange. 1301 should be declared at the beginning of the sale of the first house.
Rules to follow to avoid capital gains tax through a 1301 exchange:
- The property must not be your primary residence
- There must be a third party that should hold the money from the sales. The money can’t be held by you
- You must get a new property within 45 days after the first sale. This should be in writing.
- You should use the profit from the sale to close off the second sale within 180 days after the first sale.
You have to follow the IRS rules and you should have a third party that would hold the money while you sell and buy the new house. If you then decide to cash out the money, then you will be paying all the capital gains tax you owed.
If you are just a house owner and you want to avoid capital gains tax, you can’t use the 1301 exchange. You just have to meet with the IRS requirements of having lived in the house for two years and not get above the excluded amount of profit after the sale of the house.
Also, your annual income will determine if your gains would be tax-free or not.
Capital Gains Tax Exemptions for Primary Residence
Ownership Test
One way to be exempted from the capital gains tax when you sell your house is that you are the owner of the house. This means you bought the house to make it your primary residence. If you rented the house, you obviously can’t sell it.
Use Test
Another way to be exempted from the tax is to pass the use test. You should have lived in the house for two years in the last five years to the day of the sale.
Even if you rented out the house for three years, as long you lived in it for two years, you can exclude up to $250,000 from the profit if you are an individual and $500,000 for couples that are filing jointly.
If you or your spouse is a member of the Uniformed service, Foreign service, or an employee of the intelligence community of the US, you can suspend the 5 year test period if you are on qualified official extended duty.
You are on qualified official extended duty when you are ordered to service for an indefinite period or a period of 90 days, or you are serving at a duty post that is at least 50 miles from your main house or you are living in the government quarters.
What Happens if You Sell a House and Don’t Buy Another?
If you sell your house as a real estate investor and not buy another, you’ll have to pay capital gains tax. This will reduce your income. But for homeowners, you just have to meet the IRS requirements. If you meet them, you don’t have to buy another house even after selling your primary residence.
Final Thoughts
People try to avoid paying capital gains tax because you pay taxes on almost all things. There are different exceptions to paying the tax. The exceptions for a primary residence are different from an investment property. You have to be familiar with the IRS rules so you won’t be breaking any.
