A Little Secret About Capital Gains Tax
The Tax Secret That Put Thousands In My Pocket From Real Estate
We all typically cringe each spring when we’re writing a big fat check to the IRS. Paying taxes isn’t anyone’s favorite thing to do. But, what if there was an IRS rule that could potentially put thousands of dollars in your bank account — instead of Uncle Sam’s?
In 2011 I bought a foreclosed home for $77,000. In 2013, I sold that home for $113,000. Over the course of those two years, I put around $10,000 into fixing up the home: new paint, new tile, new counters, etc. When I sold the home for a pretty good profit, especially during a recession, I paid $0 in taxes. Not a penny went to Uncle Sam. It all went into my bank account.
Thanks to the IRS Capital Gains Exclusion rule, a homeowner that sells a house for a profit isn’t required to pay capital gains taxes on the profits. For me, this exclusion rule lead to wealth building, real estate investing, and financial freedom.
So how does it work? There are three main aspects of the capital gains exclusion rule: primary residence aspect, the length of residence requirement, and the financial exclusion cap.
The Primary Residence Aspect
This exclusion exists to benefit one set of people: homeowners. It’s not intended to benefit real estate investors. In order for a property to qualify for the exclusion, it must have been your primary residence. If you’re trying to sell your vacation home in Key West, it won’t qualify.
The Length of Residence Requirement
Arguably, this is the most important requirement to be eligible for the capital gains exclusion. Not only must the property have been your primary residence, but it must have been your primary residence for at least two of the last five years. However, those two years don’t have to be consecutive. Those two years can be separated within the last five years. Any home that is sold under the two year mark, even if it was your primary residence, is subject to capital gains taxes. In addition, you can only claim one capital gains exclusion once every two years. According to the IRS, “Generally, you’re not eligible for the exclusion if you excluded the gain from the sale of another home during the two-year period prior to the sale of your home.”
The Financial Exclusion Cap
The IRS is pretty generous with how much they allow you to exclude. For a single person, they can exclude a gain up to $250,000 and for married people, they can exclude a gain up to half a million dollars.
The gain is calculated by taking the sale price less the purchase price, repairs, Realtor fees, and expenses. For example, if you purchased a home for $100,000 and it was your primary residence, and over the course of two years, you put $20,000 into fixing it up. Hypothetically, after two years, you were able to sell that property for $150,000. From the $30,000 difference, you would subtract any bank and Realtor fees. That would give you your actual gain amount. In this scenario, your gain might be closer to $20,000.
The Fine Print
You’re probably saying right now, “there’s gotta be a catch.” The catch is that this exclusion isn’t designed to benefit real estate investors. If you own rental properties that you’ve never lived in, you will most likely pay capital gains taxes if you sell them for a profit. If you own a condo in Destin that you vacation at for a month or two a year, you will most likely pay capital gains taxes if you sell it for a profit. If you try to claim the exclusion on two properties in the course of two years, you will most likely pay capital gains taxes on one of them.
Three things to ask yourself before deciding to take the exclusion:
- Was this my primary home?
- Have I lived here full-time for at least two years over the last five years?
- After fees, is the gain under the allowed threshold?
It’s also important to note that the five year period could potentially be suspended if you or your spouse were in the armed forces.
Furthermore, this article is intended to be an introduction to the capital gains exclusion. You certainly want to consult a CPA regarding the specifics and how it impacts your current situation.
How Did This Exclusion Change My Life?
At the time I bought that house for $77,000 in 2011, I was heavily in debt due to student loans. I was barely grossing $24,000/year. I owed over $70,000 in student loan debt. Over the course of six years, I bought fixer upper homes, lived in them, fixed them up, and sold them for a profit. I was able to keep all of my profits due to the exclusion, and I used large portions of those profits to eventually pay off all of my student loan debt. Of course, that meant I moved every two years, I lived in construction zones, but it also meant I got pretty good at busting out walls, laying tile, and painting. For me, I found no other method that allowed me to write big checks to my student loan company than living in construction zones and building equity.
The financial freedom I experienced due to paying off my student loans led me to dive into real estate investing. I now have $0 in student loan debt, I have flipped seven houses, I run an AirBnb, and I’m a full-time Realtor in Northwest Arkansas.