Firstly, it is worth knowing exactly what a “capital gain” is. You may already know but just to reiterate, it is the profit you make when you sell/dispose of an asset that has increased in value. It is the profit (more commonly referred to as the gain) that is subject to tax. Here is a very basic calculation:
Proceeds of sale $100,000
Less:Original purchase price ($50,000)
Chargeable gain $50,000
This is a very simplistic calculation. In reality, you would need to take into consideration the costs of sale (such as agent fees), capital improvements, outstanding mortgages and, if the sale is in a foreign currency (not USD), then exchange rates on purchase and sale. For more detailed information on the calculation of a gain please contact us directly.
Continuing from the above example, where you have made a gain on the sale of your property, you should now consider your exposure to US tax. To start with you will find it useful to know that you are able to exclude some, if not all, of the capital gain made on the sale of your main home or “Principal Residence” (IRC S.121). Subject to a number of conditions, you are able to exclude:
Up to $250,000 of gain
If you are married and file a joint return with your spouse, then the tax-free amount increases to $500,000
There is always a “but”, in this case, there are a few. Under Section 121;
You must have owned and used the property as your main home for at least two out of the previous five years ending with the date of sale.
You must not have claimed the main home exclusion in the previous two years ending with the date of sale.
For joint filers looking to claim the $500,000 exclusion;
One of you needs to meet the ownership test
Both of you need to meet the lived-in test
Neither of you must have claimed the main home exclusion in the previous two years ending with the date of sale.
On a positive note, you do not necessarily have to be residing in the property at the point of sale to benefit from the exclusion. The “owned and used” test ends with the date of sale. Therefore, you may not have lived in the property for up to three years and you would still be eligible for the relevant tax-free amount.
It is not all good news unfortunately. In the event that you make a loss on the sale of your main home, the loss is not deductible in any circumstance.
If you have made a significant gain on the sale of your property, whereby you exceed the main home exclusion that is available to you, then the amount above the exclusion is subject to US tax. The tax rate will depend on whether it is a Long-Term or Short-Term gain (please note that any taxable gain, after the main home exclusion, will always be a Long-Term gain);
If you have held the property for more than one year, then this is considered a long-term gain for which the tax brackets are 0, 15 or 20%, depending on your applicable income tax rate.
If you have held the property for one year or less, then it is considered a short-term gain and is taxed at the relevant income tax rate which ranges from 10% to 37% (for the newly updated 2018 tax rate schedule please see our US Tax Changes article)
Capital gains in excess of the main home exclusion are also subject to Net Investment Income Tax (NIIT). As the name implies, this is additional tax on your net investment income which includes; interest, dividends, royalties and capital gains. (This is by no means an exhaustive list). The rate of NIIT for 2017 is 3.8% and it is in addition to any tax that you may already be paying.
What if I don’t meet the ownership requirements to qualify for the main home exclusion?
The tax treatment on the sale of a property which you have not lived in differs from the sale of your own home in that the $250,000 (or $500,000) exclusion is not available to reduce the gain made on the sale of your investment property*; thereby leaving the entire gain liable to US tax at the rates mentioned previously.
*Please note that this does not include property that has been used in a trade or business.
You will be glad to hear that if the property is not your principal residence then you are able to utilise any loss made on sale. The loss will be available to offset other capital gains and the first $3,000 of residual loss (or $1,500 if filing separately from your spouse) is deductible against your ordinary income.
What if I am selling a rental property?
This is a little more technical. Real property that has been used in a trade or business for more that one year is known as Section 1231 Property (or more specifically Section 1250 Property). If you have been reporting this rental income on your tax return, then you are probably aware that you are required to depreciate the value of your property over 27.5 years (or 40 years for non-US property). This essentially takes 1/27.5th (or 1/40th) of the value of the building as a deduction against your rental income each year. You may not be aware that when you sell a rental property you are required to “recapture” this depreciation.
To calculate the capital gain made on sale of your rental property you must reduce the cost basis of your property by the depreciation claimed to arrive at your adjusted cost basis.
Here is a basic example. You bought a property 3 years ago for $100,000 and rented it out immediately. You claimed $9,000 of depreciation as a rental deduction over the 3 years. The adjusted cost basis of the property is $91,000.
If you sell your rental property for a gain, using the adjusted cost basis, then the gain up to the amount of depreciation claimed, is subject to a maximum 25% tax rate. Any gain above the amount of deprecation claimed is subject to the Long-Term capital gains tax rates mentioned previously.
Back to our example, let’s say that you sold your property for $150,000. Resulting in a gain of $59,000. The first $9,000 is subject to a maximum tax rate of 25%. The remaining $50,000 is subject to Long-Term capital gains tax rates.
*Please note that this is very basic calculation and does not take into consideration any additional depreciation which is taxed at ordinary income tax rates.
But it is not all doom and gloom. The depreciation deduction against your rental income, as well as other deductible expenses, may well have been producing a rental loss each year. Rental losses can only be utilised against other rental income (or other passive activities) or are carried forward as a “Passive Activity Loss” until the property is sold. You are able to crystalise these rental losses on sale of the property and deduct them from your chargeable gain and other income on your return, reducing your exposure to US tax.
What if I made a loss on the sale of my rental property?
And now for some good news, a loss made on the sale of your rental property is an ordinary loss and is fully deductible against your ordinary income.
Please be aware that the above information only relates to US tax. We strongly advise that you consider the tax implications of any foreign country that you live in or the country in which your property is situated. In addition, foreign exchange variations need to be considered, especially if there is a mortgage attached to the property.
This article is intended for informational purposes only. No responsibility will be taken by PJD Tax Consultants Ltd on any actions taken by yourself based on the information provided. You should therefore seek professional advice if you are considering selling your residential property.