Taking The Pains Out Of Capital Gains

By Lisa Scontras

Capital gains tax laws are set to expire at the end of this year. And if you think the only people who care about this are wheeler-dealer real estate investors, you might be surprised to learn how capital gains may affect you.

First, the basics: Capital gains is a tax charged on the profits realized from the sale of an asset such as, but not limited to, a piece of real estate.

But despite a common misconception, the tax does not apply only to investment property. It applies to your principal residence as well. The difference is in how the capital gain is computed for profits made from the sale of your primary residence.

Currently, an individual living in their home for at least two of the last five years can exclude the first $250,000 of profit from the sale of the home and married couples can exclude the first $500,000 of “gain.” Any amounts realized over these figures are subject to capital gains tax.

The kicker is that there is a possibility that capital gains tax rates could change on January 1, 2011. If that happens and if you are planning to sell your home in the near future and think you will be subject to capital gain, it might be worth considering selling sooner rather than later.

But, here are two ways that even with this sweet exemption, you could end up with a hefty tax bill when you sell:

1. If you own a home and have more than $500,000 in equity ($250,000 if you are single), which in Hawaii is not uncommon, you will be required to pay capital gains tax on any gains exceeding that amount.

“Some people are going to be surprised if they have $800,000 in equity, how much of that will go to pay taxes,” says Greta Richardson, sales manager at Prudential Locations. “Especially when you consider that for most people, the bulk of their assets are in real estate, it is very important. We’re making it a priority to educate our clients and consumers about capital gains and guide them to talk to a tax professional.”

2. If you’re married and entitled to the $500,000 exemption, and then your spouse dies, you only have two years to retain the “married” status. After two years, you will be considered single and only allowed to claim the $250,000 exemption before being taxed when you sell.

“If you have parents, grandparents, aunties or uncles with equity, this is definitely something that you want to explain to them while everyone is healthy, before someone becomes sick,” says Richardson. “Bringing it up now is much better than when someone is grieving.”

Here’s what we know: Currently, long-term capital gains are taxed at 15 percent. Tax cuts enacted in 2003 lowered the rate from 20 percent to the current rate to give Americans the incentive to save and invest. But that law expires at the end of this year.

“Congress will have three options, to extend it, let it expire, or extend it with changes or modifications,” says Richardson. “Last month when Congress was in session, they decided not to discuss taxes or vote on it right now because it’s a controversial issue. But after the November elections they will most likely make a decision and the consensus is they will either extend the current rate or increase it to 20 percent. And at that point, it might be too late to list and sell your property by the end of the year.”

So who will the capital gains tax debate affect most?

“Even the person who owns one or two income properties may be affected,” says Richardson. “But it really affects nearly everyone. When our agents explain this to clients, they say, ‘Oh my goodness, my parents or grandparents should know this.’ And suddenly, they’re interested.”

As in all tax matters, it is best to consult a tax expert or estate planner for the details and occupancy requirements.

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