Refresher on Capital Gains Taxes – Primary Residence Sales
Many people aren’t familiar with the effects of selling property that has appreciated in value, and whether they are about to incur a capital gain tax with a sale. It helps to have an awareness of current capital gain tax rates, the potential added tax from the Unearned Income Medicare Contribution Surtax (to help fund the Affordable Care Act), and the IRS capital gains rules in effect now, vs. old rules that many still think are in place.
This writing summarizes the basics of capital gain on the sale of a primary residence so that you are alerted to a potential tax obligation and can get help from your tax professional to prepare. An example of capital gain is provided as well.
Capital Gain on stock or investment real estate is not addressed in this writing. Specific tax questions should be discussed with your tax professional.
The “Old” Capital Gain Rule That Ended in 1997: It was known as the “roll-over replacement rule”. When selling a primary residence at a gain, the IRS regulations provided that if the seller purchased a new primary residence, up to 2 years before or after the sale, at equal or greater value than the property that was sold, then all capital gain taxes could be deferred until the replacement property was eventually sold.
Capital Gain Rule implemented in 1997: For the sale of a primary residence, for married couples filing a joint return, gain of up to $500,000 is excluded from taxation. For singles, the exclusion is $250,000.
The homeowner must own and occupy the residence for 2 out of the last 5 years to qualify. Timing matters when selling a home that was converted to a rental.
What is Gain? An Example:
Original Purchase Price in 1995: $500,000 (Also known as the Basis)
+ Improvements $200,000 (New Kitchen, new bathrooms, addition)
= Adjusted Basis $700,000
Sales Price in 2022 $2,500,000
Less 7% Cost of Sale: -$175,000 (Sales commissions, closing costs, prep)
Less Adjusted Basis: -$700,000
Less Cap Gain Exclusion: -$500,000 (Married sellers)
= Estimated Capital Gain: $1,125,000
Note that the example estimates the taxable gain, not the sales proceeds, which is a different calculation. If we assume there is no mortgage on the property, after subtracting the Cost of Sale, the estimated sales proceeds are $2,325,000. Never assume that sales proceeds is the same as capital gain.
Note that mortgage debt does not offset capital gain. A mortgage paid off at sale closing has nothing to do with the capital gains tax calculation.
Capital Gain Tax Rates – The Basics:
The Federal capital gains tax rate increases from 15% to 20% for singles earning $459,750+, and couples earning $517,200+. Bear in mind that it is the Adjusted Gross Income, which includes taxable gain, that can land you in the higher tax rate. The base California tax rate is 9.3% (top rate is 13.3%) in additional to the federal tax.
Our gain of $1,125,000 in the example is “unearned income,” meaning not from a business or employment, and it would be included in Adjusted Gross Income on your tax return. There are other variables that will impact how much the total tax would be. That is why talking with a CPA or tax professional is so important.
The Unearned Income Medicare Contribution Surtax rate is 3.8% of net investment income, or modified Adjusted Gross Income over $200,000 for singles, and $250,000 for married couples filing a joint return. This is a different threshold than the capital gain income threshold from moving from 15% to 20% tax rate.
In our example with $1,125,000 in capital gain included in Adjusted Gross Income, the tax rate would be a blend of 15% federal tax up to our married filing jointly income threshold, 20% on AGI above that threshold, 9.3%+ state of California income tax, 3.8% Medicare Surtax on AGI above $250,000 for married filing jointly.
We can assist with questions on how to plan for a home sale and new home acquisition and help you to roughly evaluate if you may expect a taxable gain. We are glad to help you in planning for such an exciting transition. Your tax professional is very important in your planning so that you are prepared.
Personal Financial Advisor, CFP® email@example.com
Disclaimer: Client tax situations are unique and specific, and you are encouraged to consult a tax professional to analyze your specific situation. This material has been prepared for informational purposes only, and is not intended to provide tax, legal or accounting advice; nothing contained in these materials should be taken as such. The opinions expressed in this article are not intended to provide specific advice or recommendations for any individual or on any specific tax strategy or security. The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Opes Wealth Management cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Advisory services are only offered to clients or prospective clients where Opes Wealth Management and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Opes unless a client service agreement is in place.