Besides the rates listed in the table, higher-income taxpayers may also have to pay an additional 3.8% net investment income tax.
What is your cost basis?
In this discussion, profit is the difference between the sale price of a property and your cost basis. This is important: Your cost basis and the price you paid for the property can be different.
Be sure to include the purchase price and other expenses from acquiring the property. As an example, legal expenses you paid at closing should be included in your cost basis.
Also, add the cost of major improvements. If you put an addition on the property, added a swimming pool, or renovated the kitchen, add the price to your cost basis.
Let’s say you paid $200,000 for your home and paid $3,000 in various expenses when you bought it. A year later, you spent $20,000 adding a swimming pool and $15,000 adding a garage. Your cost basis in the property would be $238,000.
One big exception is when you inherit a property. Whenever you inherit a capital asset, your cost basis is the asset’s fair market value at the date of death. In other words, if your parent paid $20,000 for their home in the 1950s and left it to you in 2018 when it was worth $300,000, the latter amount would be your cost basis.
With rental properties, there’s another potential tax issue. Each year, owners of rental real estate can claim a depreciation expense to lower their taxable income. The downside is that the depreciation also lowers the cost basis in the property. When a rental property is sold, the owner must pay the tax benefits of depreciation back to the IRS. This process is known as depreciation recapture.
Imagine you bought a rental property with a depreciable value of $200,000. You can take a depreciation expense of $7,273 per year. This is a big benefit on a year-to-year basis, but it really adds up over time. If you sell the property after 10 years, for example, you’d have nearly $73,000 worth of taxable depreciation recapture.
Two big exceptions
While profits from the sale of real estate are capital gains, there are a couple of big exceptions you should know about. The first is a special rule that allows you to exclude a certain amount of profit when selling a primary residence. The other is a way to defer capital gains taxes when you sell an investment property.
The primary residence exclusion
If you have a capital gain that results from the sale of your main home, the primary residence exclusion could help you avoid capital gains taxes.
In a nutshell, you can exclude as much as $250,000 of capital gains from your income. If you file a joint tax return with your spouse, the exclusion cap is doubled to $500,000. To qualify, the sale needs to meet two criteria: