Taxable gains on real estate sales are determined based on the type of real estate that you are selling, whether or not the property is part of a business and how long you have held the property. Under 26 U.S.C. (United States Code) section 121, sellers of their primary residence can pay zero capital gains taxes up to specified levels. However, rental or investment properties are taxed as either ordinary income or capital gains. For instance, rental income and short-term real estate sales are considered income, whereas real estate held long term (over one year) is a capital gain.
Capital Gains vs. Ordinary Income Taxes
Capital gains are preferred tax rates paid on the difference between what you paid for an investment versus the price received upon the sale. Ordinary income tax rates are based on the amount of money that you make in wages or interest income. Federal income tax rates range from 10 to 35 percent through 2012. Also, depending on your state, you may owe state income or capital gains taxes. Capital gains tax rates are based on your income tax bracket and range from zero to 15 percent for long-term capital gains. Any short-term capital gain is taxed at your individual income tax rate.
Residential vs. Investment Property
Primary residential properties are tax-preferred assets. If you are selling a primary residence and have lived in the property for two of the last five years prior to the sale, you will owe the IRS zero taxes on gains up to $250,000 if single, or $500,000 if married. Amounts over the thresholds are taxed as long-term capital gains. Investment property sales are taxed as capital gains based on an "adjusted" basis, whereupon you calculate the purchase price, plus improvement costs, minus depreciation, which equals the adjusted basis. The gain is calculated by taking the sales price and subtracting the adjusted basis and the sales costs.
1031 Exchange Tax Benefit
Under IRS tax code section 1031 exchange (Starker exchange), an investor can avoid capital gains taxes by exchanging the investment property for a "like-kind" (similar type) property. To qualify, the property needs to be owned by you and used for investment purposes (or an ongoing business enterprise) and must be of like-kind, but not necessarily of equal quality. If the transfer involves money, unlike properties or the like-kind transfer results in transferring liabilities, then a tax liability may exist. Check with a real estate tax attorney prior to executing such an exchange.
Real Estate Investment Basics
Whether you are buying a home or purchasing an investment property, there are certain factors to consider. The first is whether or not your particular state is going to tax the sale of your property and at what percentage rate. Second, determine your income tax bracket, because your capital gains tax rates are based on your income level. If renting out property, ascertain whether your local jurisdiction views rental income as a business. Finally, be aware of the particular market in the area that you are purchasing real estate, because real estate markets vary dramatically across the U.S., which will affect profits.
Grant Houston has been writing since 2000, covering various political, business and market events. With a Bachelor of Arts in economics and political science, he has written articles for "Political Economic Review," UmarKit, LLC and Shadow Company. Houston has also authored business plans and consulted with companies on capital acquisition strategies.