A homeowner who plans to sell their home before two years could face a significant tax penalty known as a capital gains tax. To avoid tax penalties, a homeowner should wait two or more years before selling their house. However, we know this isn’t always the case, and sometimes unexpected situations may arise, which may require you to sell your home.
For homeowners who need to sell their house earlier, there are strategies they can take to minimize their tax penalties. Below, we’ll discuss the true definition of capital gains tax, steps to avoid tax penalties when selling a house before 2 years, and any tax implications of selling a house below market value.
What is Capital Gains Tax?
Capital gains tax is defined as the profit from a house sale and is typically considered taxable income. Depending on the state, many homeowners who sell their house must pay their capital gains tax at a state or federal level.
If a homeowner makes a profit when selling their house, they’ll have to pay taxes on the amount between the purchase and sale prices. However, it’s possible to deduct costs from the sale price of the home, which can reduce the amount of tax to pay.
Tax deductions might include the following:
- Real estate agent commission fees
- Attorney costs
- Title search charges
- Closing costs
- Escrow fees
Once a homeowner has calculated their capital gains tax, the final tax bill will be determined by several factors. If the homeowner has owned their home for less than a year, they’ll pay short-term capital gains taxes. If the homeowner has owned their home for more than a year, they’ll pay long-term capital gains taxes.
It’s essential to know, however, that some states don’t have capital gains taxes.
3 Steps to Avoid Tax Penalties When Selling a House Before 2 Years
Here are three steps a homeowner can take to avoid tax penalties when selling a house before 2 years.
1. Live in Your Home for 2 or More Years
When a homeowner stays in their home for more than 2 years, they can reduce their amount of capital gains tax. Single homeowners can exclude their first $250,000 of capital gains. Homeowners who are married can exclude their first $500,000 of capital gains.
For a homeowner to qualify for a capital gains exclusion, they must own and live in their own home for at least two out of the five years before they sell their home. Once they’ve applied for a $250,000 tax exemption, they would have their capital gains tax decrease.
2. Installment Contracts
Another tip we can give to avoid a capital gains tax penalty is to have an installment contract when selling the home.
With an installment contract, a person will make a down payment, followed by monthly payments, until the property is owned. By taking this approach, a homeowner can spread their tax burden over multiple years, even though they’ll still have to pay the total amount.
If the homeowner wants to take this approach, they should create a guideline and timeline on how long they’ll be paying. The homeowner should also be aware of how to report their income due to regulations and limitations of their installment payments.
3. 1031 Exchange
If the homeowner is selling an investment home, they can do what’s called a 1031 exchange to defer paying their capital gains taxes. In the majority of situations, however, 1031 exchanges don’t typically apply to primary or secondary homes.
For the homeowner to conduct a 1031 exchange, they have an investor sell the investment property and use any proceeds to buy another similar one. When using a 1031 exchange, there isn’t a limit on how many times a homeowner can use this.
However, it’s vital to time the sale of the property carefully. The homeowner needs to close on their new investment property within 180 days of selling their old house.
If you need more guidelines on selling your home before you’ve owned it for 2 years, our experts at InsightfulREI can help!
Tax Implications of Selling a House Below Market Value
Around eight percent of people plan on selling an inherited house. But the question remains, “Are there tax implications of selling a house below market value?” It’s possible to sell an inherited house, but a homeowner should be prepared to handle tax implications and other financial situations in the process.
While it’s not set in stone, a homeowner will have to pay taxes when selling a house below market value; they might have to pay a gift of equity to the IRS. The homeowner should also be aware of capital gains taxes for the relative who is receiving the house if you’re selling an inherited house.
What Does Selling Below Market Value Mean?
When a homeowner sells their house below market value, this means they’re discounting their home under the perceived market value. Perceived market value is defined as the best estimation of the home’s value based on other similar properties. A home’s market value is ultimately how much the buyer will pay for the home.
However, it’s essential to note that market value is different from appraised value and assessed value.
Reasons to Sell a House Below Market Value
There are always homes out there that are selling for below market value, whether it’s due to personal circumstances or some other reason. Here are some of the most common reasons why a homeowner will sell their house below market value.
1. Selling an Inherited House
Whether the homeowner is being generous or just plans to sell an inherited house, they’ll sometimes consider selling their home below market value. Even if they’re selling to someone they know, it’s still considered a contract. The most common type of inheritance is when parents sell their kids a house.
When selling a house to a family member below market value, it’s essential to keep some of these tips in mind.
- Sign a contract – Even if the seller is selling their house to their child, it’s crucial to get everything in writing, just like they would if someone else were buying the home. The seller should also keep documentation of any contingencies, closing date, and purchase price.
- Know tax laws – If someone sells their house below market value, the IRS will view the home as a gift. This means that whoever is inheriting the home might have to pay a gift tax on the below-market value amount. To help out, the seller can offer seller financing, plan for future tax-free gifts, and transfer the property with a quitclaim deed.
2. Poor Open Market Performance
If the house has been on the market for a long time, and the seller has only received low offers, the owner might consider selling the home below market value. Poor performance is mainly due to houses being priced incorrectly. If the seller has been comparing their home to other homes that are in better condition, they’ll need to post a more reasonable price.
How quickly a home sells depends on the current state of the real estate market as well. If it’s a hot market, a seller could receive a full-price offer. In a slow market, a seller might receive lower offers before getting the right one.
However, some sellers can’t wait and will take a low offer just to close the deal.
3. Low Listing Price for a Fast Sale
There are some circumstances where a seller will intentionally put their home up for below market value to sell their home faster. There are many reasons why a seller might need to put their home quickly, such as personal or job-related reasons.
If the seller isn’t concerned too much about profit, there are some strategies for selling a house fast.
- As-is pricing – To the naked eye, the home might look like it’s of equal value to comparable homes, and if it’s a hot market, the house may sell quickly. However, once inspection approaches, the seller could pay more for pre-closing repairs. In this case, the seller might want to sell their house below market value from the start.
- Cash buyers – To reduce listing time, cash buyers are the best route to take. Cash buyers will typically close fast and don’t require financing.
4. Financial Hardships
If the seller is going through financial hardships, the lender might agree to a short sale. With a short sale, a lender will allow the seller to sell their home for less than what’s owed on the mortgage.
Remember, short sales aren’t a way to get out of a mortgage. The lender will need a letter of financial hardship status for proof that the seller needs a short sale. If the price is too low, the bank may also reject the short sale.