Real Estate Gains: Maximize Your Capital Gains Tax Exclusions
As a broker and real estate attorney of nearly 30 years, one of the most common questions I face is how clients can best maximize their capital gains tax exclusions. Capital gains taxes are a tax on profits realized from the sale of highly appreciated real estate property, art, businesses, stocks, or other such assets.
To calculate capital gains taxes, the general rule is to take the sales price of your property and subtract the transaction costs to establish your net proceeds from sale. Then deduct from your net proceeds your original purchase price, and also subtract the costs of capital improvements (those affecting the sales price: new roof, yes; paint job 15 years ago, no) which will yield your capital gain. Thus, if you purchased a home in 1990 for $800,000, then did $200,000 of capital improvements over the next 30 years and you sold it in 2022 for $4,000,000 at a 5% commission with 1% closing costs, then your net proceeds would be $4,000,000 x 0.94 = $3,760,000 minus your original purchase price of $800,000 = $2,960,000 and then minus the $200,000 of capital improvements for a capital gain of $2,760,000. It does not matter if you had financing or not. Many people conflate cash position after sale, which includes paying off your mortgage, with capital gains – but the concepts are unrelated.
Capital gains tax rates are normally between 15-20% in federal taxes on long-term gains for properties owned more than one year (varies according to income level), and 37% for short-term gains under one year. California, on the other hand, taxes capital gains at the ordinary income rate. Also, after such sales, any depreciation taken on the property is “recaptured.”
The good news is that if you have lived in your property for at least two of the past five years as a primary residence, then each spouse has a $250,000 exclusion from capital gains taxes. Thus, for a married couple owning the property above, the taxable capital gain would be reduced by $500,000. No longer are you required to purchase a new property for this exclusion, and you can take this exclusion every two years.
Meanwhile, real estate investors who own non-owner-occupied properties often defer their capital gains taxes (typically until they pass away and hand down their properties with a new “stepped up basis” that starts the count over) by using “Starker Exchanges” under Internal Revenue Code section 1031. In such cases, the investor sells a highly appreciated investment property, transfers the sales proceeds to an accommodator, and that accommodator uses the funds to purchase a replacement property that is then transferred to the investor. If properly conducted, the exchange is not taxed for capital gains because the investor never realized the profit, simply rolled it over into a new investment. There are strict time limits, the property must be of “like kind” (basically another investment property), and any existing debt must be carried through. This is a very popular way to defer capital gains taxes.
Here’s where you can really maximize your capital gains exclusions. In today’s day of granny flats and ADU’s, there is a perfect opportunity to meld these two strategies together. If you rent a room, a guest house, or more on your property, then you can allocate a certain percentage of your sales proceeds to “investment property” represented by those rentals, while also claiming your primary residence exclusion. Thus, in the $4 million example above, if the property includes an ADU that arguably brought 25% of the sales price, then the capital gain could be further reduced by $1,000,000 that would be transferred into a new investment property on which capital gains taxes will be deferred. This is called a “hybrid exchange” and can certainly save a great deal of capital gains taxes.
With today’s very high real estate values this is a factor to consider in each sale. Before selling your highly appreciated real estate, be sure to visit with an experienced CPA or real estate attorney to plan and maximize your capital gains exclusions. There are many other ways to defer or reduce capital gains taxes including seller financing, “lease to own” contracts, investing in opportunity zones, and selling real property during years in which you’ve experienced capital losses from other investments.
John J. Thyne III is an attorney and senior partner of Thyne Taylor Fox Howard, LLP; a real estate broker and co-owner of Goodwin & Thyne Properties; and a professor of law.