When people plan to sell real estate, they often consider what tax they will pay on the sales proceeds. Generally, the tax, if any, that is involved in the sale of investment property is capital gains tax.
Capital gains tax is a tax calculated against the amount of money earned solely by property that increased in value by its very nature and not by virtue of a person’s earned income (wages), rental income or interest earnings. A person’s pay, rental income and interest earnings are subject to income tax. Generally, capital gains tax rates are lower than income tax rates.
Typically, capital gains tax becomes a consideration when someone sells stocks, bonds or real estate. The process of calculating capital gains tax liability ranges from somewhat simple for some publicly traded stocks and bonds to very complex for some real estate.
Generally, the first step in calculating capital gains tax liability is to determine the cost to acquire the property. That cost to acquire is usually called the property’s initial “tax basis.”
If the property is real estate, the tax basis can increase for physical improvements invested in the property. Similarly, the tax basis can also decrease based upon the amount of improvements that are “depreciated” on the owner’s annual tax returns. In other words, the cost to acquire property, increased by improvements or decreased by depreciation, becomes the “adjusted” tax basis.
Capital gains tax is generally calculated against the difference between the sale price of property and its adjusted tax basis.
For example, let’s presume that I buy an acre of land for $1 and make no improvements to that acre and take no depreciation on any improvements on that acre. My tax basis would generally be $1. Later, I sell that acre of land for $5. The difference between the sales price ($5) and the tax basis ($1) is considered my “gain.” In that instance, my capital gains tax liability would be the capital gains tax rate multiplied by my gain: $4.
Using the same example, let’s presume that I give that acre to my brother before I die. My brother would acquire my tax basis and could owe capital gains tax when he sells that acre.
However, if my brother acquires the acre from me when I die, through my will or trust, the tax basis in the acre would increase to the fair market value of the acre as of the moment of my death. Accountants call this increase in the tax basis a “step-up.”
Generally, the higher the tax basis, the smaller the gain. Generally, the smaller the gain, the less capital gains tax is owed.
Very importantly, when people sell their primary residences (houses), typically, the first $250,000 or $500,000 (for couples) of gain can be ignored. Therefore, generally, if an unmarried person sells his or her house for up to $250,000 more than the amount paid when the house was first purchased, that money is acquired capital gains tax-free.
Lee R. Schroeder is an Ohio licensed attorney at Schroeder Law LLC in Putnam County. He limits his practice to business, real estate, estate planning and agriculture issues in northwest Ohio. He can be reached at Lee@LeeSchroeder.com or at 419-659-2058. This article is not intended to serve as legal advice, and specific advice should be sought from the licensed attorney of your choice based upon the specific facts and circumstances that you face.