Let’s say that you’re in the market of flipping houses to sell for a profit later. Did you know that the IRS taxes your profits? This is what capital gains taxes are. Luckily, there is no capital gains tax in Texas on real estate. But that does not mean you’re free from your tax obligations at the federal level. In this case, understanding what and how the capital gains tax works will be critical in your investment journey. With that, here’s a review of what the capital gains tax in Texas on real estate is and how it impacts investment plans and strategies.
Key Takeaways
- Texas does not impose state-level capital gains taxes, but federal tax rules still apply for profits gained from property sales.
- Sec 121 and the 1031 exchange help lower or defer capital gains taxes by lowering the applied tax rate and encouraging capital reinvestments in real estate.
- Capital gains are calculated based on the adjusted cost basis, so accurate expense tracking is essential to lower taxable gains.
The Section 121 Exclusions: How to Avoid Tax on Your Texas Home Sale
Drawing from our experience as an Austin property management company, we know that the capital gains tax in Texas on real estate is a common concern for investors. Knowing that the profits that you earn from a property sale will be deducted can feel daunting. However, there is a way to mitigate by leveraging IRS Section 121. But what is it exactly?
IRS Sec. 121 is a ruling that allows qualified sellers to avoid a portion of their property sale earnings from the calculation of the capital gains tax. However, this applies only if you owned the property and it served as your primary residence.
As per IRS requirements, this means that you should have held the title and lived in that property for at least two of the last five years before selling. Keep in mind that the “residency” does not have to be consecutive. As long as you’ve lived in the property for at least two years over the last five, then you qualify for Sec 121. Here, you can exclude up to $250,000 of your capital gains if you file as a single taxpayer, and up to $500,000 for joint filing for married individuals.
Federal vs. State: Understanding Texas’s Unique Tax Position
One of the benefits of investing in Texas is that the state does not have any state income tax. This means that your capital gains from selling your real estate assets are not taxed – at least at the state level. While this tax advantage can significantly improve your net returns, you still need to take your federal tax obligations into account.
When it comes to federal capital gain taxes, there are two distinctions used to determine the applicable tax rate depending on how long you’ve held the property – whether short-term or long-term. The short-term capital gains apply to properties held for only a year or less and are taxed normally as your ordinary income. Here, tax rates range from 10% to 37%, depending on what bracket you belong to.
On the other hand, long-term capital gains account for assets held for more than a year and offer reduced tax rates ranging from 0% to 20% only. Because of this, many investors look for long-term investment opportunities to significantly lower their deductibles and increase profit margins.
1031 Exchanges in Texas: Deferring Capital Gains on Investment Property
Aside from the IRS Sec 121, investors can also leverage 1031 exchanges to avoid capital gains tax in Texas on real estate, at least for the time being. IRC Section 1031 offers a unique opportunity for investors to completely defer capital gains and depreciation recapture taxes on a sold real estate asset by reinvesting the proceeds in a “like-kind” property. In essence, it’s like trading one property for another that is similar in type or purpose.
This is beneficial for investors looking to scale their portfolio, particularly in Texas. Given that there is no capital gains tax in Texas on real estate, more of the sale proceeds can be reinvested into larger, income-generating assets, even though federal tax rules still apply. For example, you can sell a single-family rental property and use the 1031 exchange to defer capital gains taxes to purchase a small multifamily income investment property. What’s even better is that you can continue this roll to preserve your capital for long-term growth. However, a key reminder is that the 1031 exchange follows a strict timeline. You only have a 45-day period after the sale to identify potential replacement properties, and 180 days to close the deal.
Calculating Cost Basis to Minimize Your Capital Gains Exposure
One key element of capital gains tax in Texas on real estate is that your obligation is not calculated based solely on the sale price of your investment property. Instead, the capital gains tax also considers the cost basis. This includes your initial purchase price, closing costs, capital improvements, and other expenses incurred during the sale process. Simply, the cost basis is an accumulation of all the financial investments you’ve put into the property. And, the higher your cost basis is, the lower your taxable gain is.
Here’s a quick example. Let’s say that you bought a fixer-upper for $175,000, including the closing costs. Part of your investment strategy is to completely rehab the property – installing a new roof, replacing its worn-down HVAC system, and even adding a pool as a new feature. All in all, these capital improvements and renovations cost you another $100,000. Then, you put the property up for sale, and during this time, the selling costs added another $30,000 to your overall costs. While you successfully sold the property for a whopping $550,000, you need to take into account all of your investments, amounting to $305,000. At the end, this puts your taxable capital gain at $245,000.
Now, failing to track all of your expenses can put you at greater capital gains exposure. Let’s use the same example, but this time, you aren’t able to include a portion of the costs of your capital improvements, and was only able to log $70,000 of expenses. This will bring your taxable capital gain to $275,000, which significantly increases your tax obligations.
Partner with BMG on Your Next Investment Venture
Understanding how the capital gains tax in Texas on real estate works is only the first piece of the puzzle. Utilizing this and integrating it into your investment strategy is where the real challenge comes. Whether you leverage IRS Sec 121 or opt to use the like-kind exchange through IRC 1031, planning ahead allows you to not only avoid capital gains taxes but also encourage portfolio growth. With that said, partnering with a property management company like us at BMG can provide you with the critical support and guidance that you need to succeed.
With our experience and expertise, we at Bay Property Management Group can help you track and maintain your financial records. Not only that, we’ll stay on top of everything management-wise, ensuring your property is taken care of and prepared for the next steps in your investment strategy. Interested? Don’t wait any longer and contact us today to learn more!
