Owning property in Texas affords you many opportunities to turn a profit. You can rent a property out to tenants to generate rental income, refinance a mortgage loan to take out cash for upgrades or sell a home that has increased in value for a profit.
However, it is important to understand that profiting from the sale of a home is not always as straightforward as how much you paid for it and how much it sells for since there are additional tax implications. Another factor that could impact your earnings is the capital gains tax.
What Are Capital Gains Taxes?
Capital gains taxes are state or federal taxes paid from the profits of selling an investment. Essentially, if you sell an investment for more than you paid for it, the government can claim a percentage of the profits in the form of capital gains taxes. There are two kinds of capital gains taxes: short-term capital gains and long-term capital gains.
Federal Capital Gains Taxes
Under the federal tax policy, the federal government only collects long-term capital gains taxes on investments that have been held for over a year. The amount that is taxed will depend on which regular income tax bracket you fall under, as well as any deductions or exclusions that may apply.
State Capital Gains Taxes
In Texas, there is no state capital gains tax. That means selling an investment would only require you to pay taxes on the profits to the federal government. This makes Texas an appealing state for many real estate investors to buy properties in since they only have to pay the federal capital gains tax.
Texas Capital Gains Tax Rates
Although you will not have to pay capital gains taxes to the state of Texas if you sell an investment for profit, you will need to pay them to the federal government in certain circumstances.
For long-term capital gains that are held for at least a year, the tax rate will be either 0%, 15%, or 20%, depending on the income bracket you fall under. Short-term capital gains are taxed at the same rate as ordinary income. You can always use a capital gains tax calculator if you are not sure how much it would impact your profits.
When Do I Have to Pay Capital Gains Tax in Texas?
There is no time limit for when you will pay capital gains taxes on a property that you sell. What does matter is how long you have held the property. The short-term capital gains tax rate will be applied if you have owned it for less than a year. This rate is the same as the usual federal taxable income rate.
If you hold the property for a year or more, the long-term capital gain rates will apply, which fall between 0% and 20% for the most part. In general, long-term gains are taxed at a lower rate than short-term gains.
Exemptions From Paying Capital Gains Tax in Texas
Fortunately, there are ways to avoid paying the full capital gains tax on your home sale. In some cases, you may even be fully exempt from the tax. The key numbers to know are the 2-in-5-year rule and the exclusions of $250,000 and $500,000. If you live in a home that you own for at least two out of the past five years, it is eligible for the capital gains tax exclusion. For a single person, this exclusion is $250,000. For married filing jointly, it is $500,000.
As an example, if you bought a house for $200,000 in 2020, you may be looking to sell it in 2024. As long as you have lived in that house for a total of two years during that time frame, even if it is not concurrent, you can apply for the capital gains tax exclusion. That means selling the house for $450,000 as a single person would mean you owe no capital gains tax because the profit from the sale was equal to the exclusion.
Can I Avoid Paying Capital Gains Tax in Texas?
Multiple strategies can help you avoid paying the capital gains tax on properties in Texas. Understanding these exceptions will allow you to keep more of your profits when selling an investment.
- Primary residence exemption –The profits are less than $250,000 or $500,000, depending on your filing status, and you have lived in the property for two out of the last five years.
- 1031 Exchange – Use a 1031 exchange to buy a like-kind property with the proceeds from the sale to defer the capital gains tax liability.
- Income-based exemption – If your annual taxable income falls into the 0% capital gains income bracket, you are exempt from capital gains taxation.
Decreasing Capital Gains Tax in Texas
Even if you cannot avoid the long-term capital gains tax liability, there are still some strategies to reduce your tax burden.
- Carryover of losses – Use capital losses from other investments to offset the gains from the property sale.
- Selling your main residence – Look into clauses about unexpected moves that forced you to sell the home and may qualify you for partial deductions.
- Reinvesting profits – Reinvest profits from a rental property sale into another investment property.
- Holding onto the property – By owning the property longer, you qualify for the cheaper, long-term tax rate.
- Tax deductions on improvements – When you invest in remodels or renovations, you increase the cost basis for taxation, which may lower your capital gains tax.
- Buy the property with a tax-advantaged account – If you buy your property with funds from your retirement account, you may defer capital gains taxes.
How to Report Capital Gains
When federal authorities tax capital gains, the taxes are not paid at the time of sale. Instead, they will be applied when the following tax return is filed. This means you must fill out the proper federal forms and have all the documentation needed to comply with the capital gains tax laws. Form 8949 and Schedule D are used to report capital gains on your tax return, and both long and short-term capital gains will be reported on this form.
Keeping good records is also important, especially if you end up being audited by the IRS. Keep records of all contractor services, improvements, sales, and other transactions related to your property to ensure that you are following the capital gains laws correctly.
Final Thoughts
Many property owners become discouraged when they find out about the capital gains tax. Sometimes, it can take investors by surprise. The key to making smart investing decisions for your properties is understanding how the capital gains tax works and what you can do to avoid capital gains tax payments or reduce its impact on your profits.
Sometimes, selling your home for cash can help keep it under the threshold for capital gains on home sales. If you want to close a cash deal quickly and get a fair price, A-List Properties will buy your home as-is so that you do not have to worry about cleaning or repairing the property before the sale.
Zach Shelley
Zach Shelley is a seasoned real estate investor with a diverse network spanning across the nation. As the founder of his own real estate venture, Zach is committed to offering innovative solutions to homeowners facing various real estate challenges.. Through his dedication and strategic approach, Zach continues to make a significant impact in the real estate industry, providing homeowners with alternative pathways to navigate their property transactions.
