Although it is often said that nothing is certain except death and taxes, the one tax you may be able to avoid or minimize most through planning is the tax on capital gains. Here’s what you need to know to do such planning:
What is capital gain? Capital gain is the difference between the “basis” in property (usually the purchase price of property) and its selling price. So, if you purchased a house for $250,000 and sold it for $450,000 you would have $200,000 of gain ($450,000 – $250,000 = $200,000). However, the basis can be adjusted if you spend money on capital improvements. For instance, if after buying your house you spent $50,000 updating the kitchen, the basis would now be $300,000 and the gain on its sale for $450,000 would be $150,000 ($450,000 – ($250,000 + $50,000) = $150,000). Just make sure you keep good records of any capital improvements in order to prove them in the event of an audit.
Exceptions to the tax? First, if you owned the property for less than a year, you would be subject to short-term capital gains tax rates, which are essentially the same rates as income tax. Second, if your taxable income, including the capital gains, is $38,600 or less for a single person and $77,200 for a married couple (in 2018), there’s no federal tax on capital gain. But beware that the capital gains will be included in the calculation and could put you over the threshold. Third, if your income is more than $425,800 for a single person and $479,000 for a married couple (in 2018), the federal capital gains tax rate is 20 percent, bringing the combined federal and assumed state rate up to just over 25 percent.
Personal Residence Exclusion. You may exclude up to $250,000 for an individual, or $500,000 for a married couple, of gain on the sale of your personal residence. To qualify, you (or your spouse) must have lived in and owned the house for at least two out of the five years prior to the sale. If you are a nursing home resident, the two-year requirement is reduced to one year.
Carry-Over v. Step-Up in Basis. If you give property to someone else, they receive it with your basis. So, if your parents give you a vacation home they bought for $25,000 and now its fair market value is $500,000, your basis will also be $25,000. If you sell it, your gain is $475,000. On the other hand, the basis in inherited property gets adjusted to the value on the date of death. If your parents passed the vacation home on to you at death rather than giving it to you during life, the basis would be adjusted to $500,000, potentially saving you hundreds of thousands on its sale. Similar types of savings can be realized with the appropriate use of trusts.