What are Capital Gains? — for Real Estate Investors

What are capital gains - for real estate investors
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Disclaimer: The following article is meant for educational purposes only and should not be taken as professional tax or legal advice.

The term “capital gain” refers to profit made on an asset at the time of sale due to appreciation. While capital gains are usually associated with the stock market, a capital gain can be realized on any asset that is sold at a higher price than what was originally paid—such as commercial real estate. Understanding capital gains is especially important for real estate investors, because it can help you maximize your profits and minimize your tax burden. Let’s take a look at different types of capital gains and how they are calculated.

Short-term vs. long-term capital gains

The National Association of Securities Dealers Automatic Quotation System (Nasdaq) defines short-term capital gain as any profit made from the sale of an asset you’ve held for one year or less. This type of capital gain is taxed as ordinary income, which is typically disadvantageous for the taxpayer. A long-term capital gain, on the other hand, is defined as any profit made from the sale of an asset you’ve held for longer than a year. This type of capital gain is typically taxed at a lower rate than short-term gains. Depending on your income tax bracket, long-term capital gains are taxed at a rate of either 0, 15, or 20 percent.

How are capital gains calculated?

Let’s look at a simple example to illustrate how an investor can calculate the amount of capital gain that will be generated by the sale of an investment property.

Suppose that John Smith purchases a property for $325,000, spends $15,000 on improvements, and sells the property at a later date for $410,000 (That sort of appreciation is exactly what we want to see as value-add investors!)

Capital gain can be calculated using the following formula:

Sale Price – (Purchase Price + Capital Improvements) = Capital Gain

Therefore, the capital gain on the property in our example would be:

$410,000 – ($325,000 + $15,000) = $70,000

How is capital gains tax calculated?

Continuing with the example above, let’s determine how much of a tax bill our hypothetical investor John Smith should expect.

In 2020, the long-term federal capital gains tax brackets for a single filer are as follows:

2020 capital gains tax brackets rates

Let’s suppose that John Smith has an annual income of $88,000 and held this property for 1.5 years. John will therefore pay long-term capital gains tax of $70,000 x 15% = $10,500 when he sells the investment property.

Conversely, if John had held the property for less than a year (say 11 months), then his $70,000 capital gains would be subject to taxation at the standard income tax rate. In 2020, John’s $88,000 would place him in the 24% tax bracket. As a result, he would end up paying $70,000 x 24% = $16,800 capital gains tax.

That’s a 60% increase in John’s tax bill due to short-term capital gains!

That’s a 60% increase in John’s tax bill due to short-term capital gains!

At Birchstone Investments, we typically plan to hold properties for 5 to 7 years, which qualifies for the advantageous long-term capital gains tax rate (and also allows time for considerable natural and forced appreciation).

Wrapping up

Understanding the concept of capital gains can mean the difference between profiting from an investment property and recording a loss. At Birchstone Investments, our goal is to help investors take advantage of a professionally-managed multi-family real estate portfolio in order to minimize overhead and generate the highest return from capital improvements. If you are interested in learning more about investment opportunities, join the Birchstone Investor Community today.

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Jerry Hollifield

Jerry Hollifield

Jerry is the Managing Principal & Chief Investment Officer at Birchstone Investments, LLC. With a business career that spans more than 30 years, he has been involved in the acquisition, development, financing and management of over $400 million in real estate. In addition, he has been involved in more than 40 Merger and Acquisition transactions with total value exceeding $600 million.

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