Capital Gains Tax in Tennessee: How to Avoid Surprises in 2023
Whether you invest in real estate or the stock market, you'll need to keep capital gains taxes front and center of your mind so you do not get hit with any tax surprises when you file your return. Taxes are confusing, and there's no shortage of confusion when it comes to discussing capital gains taxes. If you live in Tennessee and you're interested in learning about capital gains taxes, this article is perfect for you. We're here to clear the air and keep you informed on everything you need to know regarding capital gains tax.
What Is Capital Gains Tax?
What is capital gains tax? We're glad you asked. Whenever you sell an asset or investment and make a profit (meaning your sale price is greater than your purchase price) you earned a capital gain. There are two types of capital gains: long term and short term.
- Long-term is when there was at least a year elapsed since buying and selling the asset. For example, buying a home in 2012 and selling it in 2017 would be considered long-term.
- Short-term is when the asset was bought and sold within a year time frame, for example, purchasing a home in January of 2019 and selling it in September of 2019. This would be common for those in the real estate flipping business.
Capital gain tax is simply the tax you pay on the profit of a sale. However, there are a lot of nuances. To start, keep in mind taxes are paid at both the state and federal levels. Each state has its own capital gains tax rates, and some states have no capital gains tax at all. On a federal level, there are no escaping taxes no matter what state you live in.
Does Tennessee Have Capital Gains Tax?
Tennessee is one of nine states that does not tax capital gains on a state level. That doesn't mean residents of Tennessee, or the below 8 states, can avoid paying this tax to the federal government, but they are exempt on a state level.
The other 8 states where residents get to avoid this tax are:
- New Hampshire
- South Dakota
All of the states that border Tennessee have a state-level tax on capital gains. Arkansas and South Carolina are at the top, with a state tax rate of 7%.
Many people from across the country are moving to Tennessee as it is a tax-friendly state. In particular, retirees do not pay state tax on the income they earn on their pension, 401-k, or other retirement income sources!
How Do You Avoid Capital Gains Tax When Selling A House?
Let's first start with reviewing the exemptions where you don't pay taxes for capital gains, as that tends to be the burning question on everyone's mind. Keep in mind that these exemptions only apply if you have lived in the home for a total of two years over the past five years. This is more commonly referred to as the "two out of five rule." This two-year period does not need to be consecutive. For example, you may choose to live in your home for one year and then move. As long as you come back to live in the same home for one more year, you will satisfy the two out of five rule.
Assuming you've passed the "two out of five rule" test, you won't trigger a capital gains tax liability unless your capital gain (sale price - purchase price) exceeds $500,000 as a married couple on your primary residence. If you're single, the exemption is for up to $250,000 in profit. To be clear, this is not the value of the property. This is purely focused on the profit you made from buying and selling your home used as a primary residence.
- Married couples who purchased a home for $100,000 and sold it for $700,000 five years later, will have to pay capital gains tax as the total profit was $600,000 - however, there is some nuance which we'll cover below.
- A married couple who purchased a home for $500,000 and sold it for $750,000 five years later will not need to pay capital gains tax as the all-in capital gain was $250,000.
- A single person who purchased a house for $300,000 and sold it for $600,000 three years later would pay capital gains, as the $300,000 profit is greater than the $250,000 tax-exempt thresholds for single tax filers. Again, there is some nuance which we'll dive into below because the $300,000 may not technically be all profit.
When Selling A House How Much Capital Gains Tax Do You Pay?
First, you must determine if you are subject to short-term capital gains or long-term capital gains. We'll get into how to determine this below, however, it is important to note that long-term capital gains are taxed at a significantly lower rate. Short-term capital gains on the other hand are taxed at your ordinary income tax rate corresponding to your tax bracket.
If a married couple makes more than $500,000 profit, and a single filer makes more than $250,000, you can expect to pay taxes to the IRS as follows.
Long term capital gains tax rates for 2023:
Your capital gains tax rate as a single filer
- 0% if your income is between $0 and $41,675
- 15% if your income is between $41,676 and $459,750
- 20% if your income exceeds $459,750
Your capital gains tax rate as a married couple, filing jointly
- 0% if the combined income is $0 - $83,350
- 15% if the combined income is $83,351 to $517,200
- 20% if the combined income is $517,200 or more
Short term capital gains tax rates for 2023:
The exact rate will be equal to your ordinary income tax rate. To see a breakdown of tax brackets, click here.
It's important to mention income tax rates change, and these tax rates may not reflect the most recent year's ruling. You can use a capital gains calculator to help you understand what exactly you'll owe in taxes if you have further questions or concerns.
In addition to the above profit nuance, there is also a residency and time nuance. For the sale to be exempt from the capital gains tax, the home must have been considered the primary residence for at least two years of the last five years. That doesn't mean those two years need to be consecutive in the last five years. For example, over the course of a five year period, if you decided to live in the home for year one, rent it out for years 2, 3, and 4, but move back in year 5, you've technically lived in the residence for at least two years out of the trailing five years. Under this situation, since you lived in the home for at least two years, you would pay the long-term capital gains tax rate.
How Much Capital Gains Tax Do I Pay On A Second Home?
Most second-home sales are subject to the capital gains tax rate. There are some exceptions but the vast majority of second home sales would not qualify for the primary residence exemption, and therefore, the tax would be triggered.
How Much Capital Gains Tax Do I Pay On A Rental Or Investment Property?
Gains on an investment or rental property are almost always subject to this tax. If they are short-term capital gains, your profit will be taxed as ordinary or regular income. If you're into flipping homes, you'll need to be very mindful of how a short-term capital gain tax liability can erode profits. Your profits will be taxed at the same rate your regular income is taxed, so make sure you're familiar with the most recent years' tax bracket.
If your investment property is a long-term capital gain, meaning you held the asset or property for at least a year, your profits will be subject to the long-term capital gain tax. This tax rate is lower and is based on your income and filing status. But expect to pay between 0% and 20% in capital gains taxes.
What Do You Do If You Owe Capital Gains Tax?
If you owe capital gains tax, you made a considerable amount of profit from the sale of your home - so congratulations. Remember, if you sold your primary residence after two years and you're single, your profit must exceed $250,000. For married couples, this amount is $500,000.
You may be able to reduce or eliminate your tax burden
Despite the profit made, it doesn't mean you need to welcome this income tax with open arms. There are legitimate ways that you can lessen or eliminate the tax burden you owe.
Many homeowners have work done to their home or property over the years of living in it. Perhaps you bought a house in the early 2000s and over the years you've: renovated the bathrooms, updated the kitchen with new cabinets and countertops, finished the basement, and built a beautiful deck in the backyard. Let's say your all-in expense for these projects was $45,000.
That expense can be used to reduce the tax burden you owe. It won't eliminate the burden entirely, but now instead of being taxed on gains of $300,000 (assuming you're single), you'll be taxed on $255,000.
Using the same example, but the home improvement expenses were $51,000 instead of $45,000, the homeowner would not owe capital gains as the capital improvement expense brought the total profit below $250,000!
It's important to note, anytime you go to Home Depot or Lowes does not mean you're making a capital improvement on your house. If you're fixing something that broke or returning the home back to its original condition, that is not a capital improvement. Repairing a few cracked floorboards, or replacing a broken window won't help reduce your tax burden.
However, replacing or upgrading your furnace, adding new siding, adding a deck or addition, redoing or adding a bathroom/bedroom, removing old carpet and laying new floors, or adding overhead lighting in the rooms will all be considered capital improvements that can reduce your tax burden.
Keep a list of improvements
We encourage our clients to keep a list of improvements, and related receipts, for all the projects or upgrades they've completed to their house over the years. Not only does this land well in the eyes of any potential buyers, but it's also important in the eyes of the IRS! Anytime you buy a home, you'll always want to keep all the closing papers you were provided. These papers can come in handy down the road when you go to sell your home, so put them in a secure location that you won't forget about.
Work with a professional
We encourage you to work with a tax attorney, or CPA, in the event you owe these taxes. After all, it means you've earned a great deal of profit, you'll want to be sure you're doing everything correctly to maximize your gains.
They'll know what the IRS formula is to truly determine how much profit you made on your home. This takes into consideration; purchase price, real estate closing fees, depreciation of the asset, repair of damages to the asset expense, and any casualty loss to the asset.
How Do I Report Capital Gains On A Home Sale?
Reporting these gains on your tax return requires a bit of tax diligence. The IRS has specific forms that you'll need to fill out to report the capital gains on your home. To report capital gains on your home, you'll have to use either form 1040 or 1040-SR and Form 8949.
Looking To Sell Your Home?
Felix Homes is here to help! We're a local Nashville, Tennessee real estate brokerage and our passion is providing the best customer experience possible. We are not CPAs, however, many of our clients have asked us questions regarding capital gains taxes and it is our goal to help answer questions and provide value to our clients to the best of our ability.
Not only is a superior customer experience our priority, but buying or selling with Felix Homes also saves you money. The average real estate agent in Tennessee will charge you a 6% commission to sell your home. We firmly believe that is way too high, and a homeowner doesn't need to part ways with that much profit.
Our listing fee is just 1.5%, which means that our total commission is 4.5% vs the 6% most agents charge. On average, our clients keep an additional $12,375 per sale.
What's the catch? There is none. Many real estate companies have used the same outdated business model for 20, 30, even 40 years! Historically, the 6% fee may have made sense, but in today's technology-centered age, it's no longer warranted or needed.
Felix Homes is a full-service realtor. We'll do open houses on your home, take high-quality pictures, leverage social media marketing, and answer our client's questions at any time of the day. Just because we charge less than anyone else in the area does not mean we provide a discounted customer experience!