Tax Consequences & Deductions in Real Estate Transactions

Instructor: Ian Lord

Ian is a real estate investor, MBA, former health professions educator, and Air Force veteran.

Let's look at the tax consequences of real estate transactions. A real estate sell may have deductible expenses, taxable gains, and possibly an exception for those gains. We will also briefly cover tax rules for foreign investors.

Tax Consequences of Real Estate Transactions

When an investor sells any investment, even real estate, Uncle Sam wants to share in the profits. The tax man is coming whether it's stock, gold, or a house. But taxes are rarely simple. How much tax the seller pays depends on factors like their other income, whether they are married, and how long they owned or even lived in the home. Fortunately, sellers who know about how these factors influence taxes can make informed decisions about the tax consequences of selling their home at a specific time.

Capital Gains tax

If real estate is sold at a profit, then generally capital gains taxes are due. Capital gains is profit from the sale of an asset. This is the sale price of that asset minus the purchase and improvement costs. The United States has two different tax calculations for capital gains.

Short term capital gains are those gains made on assets owned less than one year. These gains are taxed at the taxpayer's marginal income tax bracket.

A long term capital gain is the sale of an asset that was owned more than one year. These gains are taxed at a much lower rate.

As of 2015, the long term gain tax brackets are 0%, 15%, and 20%. By comparison, income tax brackets go as high as 39.6%. A flipper or other short term owner is more likely to pay these higher tax rates. Many sellers will be able to take advantage of the reduced long term rates. Sellers who are close to passing that one year mark may consider carefully timing the transaction to pay less in tax.

Deductible Expenses

Sellers can reduce their tax burden by claiming certain deductible expenses. A tax deduction reduces the amount of gains the seller pays tax on. Let's look at a taxpayer in the 35% tax bracket. If he has a property that will have long term capital gains, every dollar in deductions saves him $0.15 on his tax bill. On a short term gain situation, he saves $0.35 per dollar in deductions.

So what can be deducted? Sellers can generally deduct closing costs associated with selling the home. Note that this doesn't include improvements or repairs made to the home. Painting and maintenance expenses, for example, would be used in calculating the basis for the sale. Paying a real estate agent's commission is a deductible expense as are legal fees, advertising fees, or any other services that helped sell the home. If the seller spent a combined $12,000 in deductible expenses, they could save up to $4752 in federal capital gains taxes if the home was owned less than one year. Uncle Sam has effectively given the seller a discount on the selling costs!

Capital Gains Exclusions

Owner occupied real estate gets favorable tax treatment from the IRS. If the owner or owners have lived in the home for at least 2 out of the last 5 years they can exclude a certain amount of the profit from taxation. An exclusion means the taxpayer does not count that income as taxable. As of 2015 the exclusion amount for a single taxpayer is $250,000. For a married couple filing jointly, the limit doubles to $500,000. For many transactions, this completely eliminates any tax bill.

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