Capital gains explained: What agents can (and can't) tell sellers

I was doing floor time last Saturday — yes, I still do floor — and was chopping it up with the weekend phone guy and a couple of other agents; I asked for questions for this column, and here we are with this week’s topic: capital gains. 

In my market, the San Francisco Bay Area, houses commonly see substantial gains upon sale, even if they’ve been owned for a short period. Capital gains exposure is a very real question most sellers have for us. While needing to ask about capital gains may not be the best feeling, it sure beats being confidently incorrect.

That is a bad feeling. I know it because I have been that agent. 

Early in my career, I could not explain in plain English what a capital gain is, how basis works or why the IRS cares about your receipts. 

I was on a listing presentation early in my career, and “I’m not a CPA,” isn’t a good look all the time.  The look that crossed my client’s face was memorable. It was the look of a person deciding I was not the professional in the room.

I am still not a CPA. But I did learn to answer the question.

Capital gains is the part of real estate that licensing school does not prepare you for. I can recite fair housing law and walk you through the purchase agreement from front to end, and it’s still a chore to explain adjusted basis.

Here is the thing that changed it for me. Capital gains is not actually about the market. It is about paperwork and planning, two things you control, rather than appreciation, one thing you do not.

Anything you’d like to see here? Questions or comments?  Email me, and remember: If you can count it, you can keep more of it.

Question: Do I have to pay taxes on money I make when I sell my property?

Answer: It depends on whether it was your primary residence or an investment property.

If it was your primary residence, you may qualify to exclude up to $250,000 of gain if single or $500,000 if married filing jointly. Generally, you must have owned and lived in the home as your primary residence for at least two of the five years before selling it. You also generally cannot have used the exclusion for another home sale during the previous two years. 

The taxable gain is not simply the money left after paying off your mortgage. It is generally calculated by comparing your sale price, minus selling expenses, with your adjusted basis. Your basis usually starts with what you paid and may include qualifying improvements. 

If the property was a rental, second home or investment property, different rules apply, but there are ways to defer paying capital gains taxes on properties held as investments.

Question: What is basis, and why does everyone keep saying that word?

Answer: Basis is how much your property is worth after all the improvements you’ve done to it over the years — at least that’s how I explain it.

Technically, basis is your investment in the property for tax purposes. It usually starts with what you paid for the property, plus certain purchase costs and qualifying improvements.

If you bought a house for $500,000 and later spent $100,000 on a kitchen, roof, windows and other qualifying improvements, your adjusted basis might be approximately $600,000. It is not automatically the property’s current market value. 

Why does everyone keep saying the word? Because the IRS uses basis to calculate your gain or loss when you sell. If you sell that property for $900,000 and have $50,000 in qualifying selling expenses, your taxable gain begins with the difference between your adjusted basis and the amount realized from the sale.

Basis can also be reduced by certain deductions, insurance reimbursements, tax credits or depreciation if the property was used as a rental. Remember to keep your receipts; you’ll need them to prove the amount.

Question: Where is the line between explaining capital gains and giving tax advice?

Answer: The line is whether we are explaining the rules generally or applying them to a client’s specific financial situation.

First off, check with your broker or your compliance officer; they know what’s best in your market, and they’re there to protect us.

Generally, I say I  can explain what capital gains are, how basis works and why the IRS may allow clients to exclude up to $250,000 of gain or $500,000 for some married couples filing jointly when selling a qualifying primary residence. 

I can also explain that the calculation generally involves your adjusted basis, selling expenses and sale price. 

Where we need to stop is getting into the dirt with our clients about details. Telling clients exactly how much tax they owe, whether they qualify for a particular exclusion, or whether you should delay a sale, convert a rental, complete a 1031 exchange or structure a transaction in a specific way is above my pay grade.

Those answers depend on facts we may not have, including their filing status, ownership history, improvements, depreciation, previous home sales, rental use, residency and income. California also taxes capital gains as ordinary income rather than providing a separate lower capital-gains rate. Probably best to check what your state or area does too.

We can explain the map. Their CPA, enrolled agent or tax attorney should tell them which road to take.