When you sell a capital asset, both the federal government and New York state impose capital gains tax. A capital asset is an asset owned for investment or personal purposes. For individuals, stocks, primary homes, bonds, and art are considered capital assets. For businesses, a capital asset is an asset that is either not used in the ordinary course of business or an asset used in the company’s business operations over the course of more than one year. For example, a car to be used by the business manager to drive to and from sales meetings is a capital asset, but a car purchased and to be sold by a car dealership company is considered an ordinary asset known as inventory.
On the federal level, capital gains tax rates are either 0%, 15% or 20% for capital assets held for more than a year, depending on your income bracket for the year.
On the state level in New York, capital gains tax is taxed as ordinary income, dependent on the amount of income gained in a year and whether you are filing your return as a single taxpayer or married couple. Most capital gains taxes are imposed on the sale of homes located in New York.
How to compute capital gains tax
Capital gains tax is a tax imposed on your capital gain, which is generally computed as the amount you sold the asset less the amount you purchased it. For example, if you buy a house in the Hamptons for $200,000 in 1970 and you sold it for $1,500,000 in 2022, capital gains tax will be imposed on your capital gain, which is $1,300,000 (1,500,000 less $200,000). The rate of the capital gains tax will depend on the income bracket for that year.
What are the strategies to minimize or defer the imposition of capital gains tax on the sale of homes?
To minimize your capital gains tax on the sale of a main home, you can discuss the following strategies with your attorney:
- sell underperforming assets where you will incur a capital loss
- if you are married, you can wait for your spouse to die to get a stepped-up basis on your deceased spouse’s share
- you can avail of the $250,000 (for single) and $500,000 (for married filing jointly) profit exemption, for as long you own the house and lived in it for two of the five years prior to sale
- utilize the 1031 tax-free exchange
- use a deferred sales trust
Selling underperforming assets
One strategy some taxpayers use to offset the gains is to sell underperforming assets. For example, if there is profit from the sale of property in the amount of $400,000, and you have stocks that you previously bought in 2019 for $100,000 but are now worth $5000, you can sell these stocks and subtract the $95,000 loss from your $1,300,000 gain, so the capital gains tax will be imposed only on $1,205,000 of capital gains.
Claiming a stepped-up basis on your deceased spouse’s share
In the example above, if you purchased the Hamptons house with your spouse in 1970 for $200,000 and sold it in 2022 for $1,500,000, you and your spouse will have a capital gain of $1,300,000. However, if your spouse died in 2021 without selling the Hamptons house, you will inherit the property from him on a stepped up basis, based on the house’s market value. If the market value of the house at that time is $1,500,000, your deceased spouse’s stepped up basis of the Hamptons house’s $100,000 share is $750,000. In that case, if you sell the property for $1,500,000, your taxable gain will now only be $650,000 ($1,500,000 less $100,000 [your share] less $750,000 [the stepped up basis inherited from your deceased spouse]).
Claiming tax exemptions if you lived in the house at least 2 years of the last 5 years prior to sale
If the property being sold is the primary residence and the taxpayer lived in the house for 2 out of the 5 years preceding the sale, the taxpayer can avail of a federal tax exemption of $250,000 from capital gains if single and $500,000 for married couples filing jointly. In the Hamptons house case above, if you are a married couple living in the property as your main home, the capital gain will be $800,000 instead of $1,300,000 because of the $500,000 tax exemption on married couples filing jointly on income arising from property lived in as their main home.
Using the 1031 tax-free exchange
A 1031 tax-free exchange allows a taxpayer to swap one investment property to another so capital gains taxes will be deferred. To qualify for a 1031 tax-free exchange, the following are the requirements:
- The replacement property must be like-kind, similar in nature and function.
- You cannot hold the money from a sale during the exchange at any time. A qualified intermediary is used to hold the funds in escrow until the replacement property is found and purchased.
- Does not apply to stocks, bonds, notes or other securities
- The taxpayer must buy the replacement property within 45 days from the sale of the previous property and close on the replacement property within 180 days of closing of the previous property, or after your tax return is due, whichever is earlier.
In the Hamptons house case, if the profit from the Hamptons house was used to purchase another property, it may qualify for a 1031 tax free exchange, provided all the other requirements are present.
Using a deferred sales trust
To defer capital gains trust, some taxpayers use a deferred sales trust. Here, property is sold to a trust on installment basis. Under the tax rules, for installment sales, you only report your capital gain on the installment. In the Hamptons house case above, if you sell your property to the third party trust for $1,500,000 on installment basis for 10 years, your annual revenue would only be $150,000 (plus interest) less your basis of $20,000 for a taxable capital gain of $130,000 annually, as opposed to having a one-time capital gain of $1,300,000. The third party-trust, on the other hand, can sell your property to another person for the full amount, while only paying you the installment amount, which allows the third-party trust to reinvest the proceeds and earn more money. Deferred sales trusts, however, have to be drafted carefully by a lawyer to ensure that it will be considered a deferred sales trust by IRS.
Above are some legal strategies to minimize or defer capital gains taxes. Should you need assistance with your real property affairs, we, at the law offices of Albert Goodwin, are here for you. We have offices in New York, NY, Brooklyn, NY and Queens, NY. You can call us at 718-509-9774 or send us an email at firstname.lastname@example.org.