Capital Gains Tax

• Capital gains income can be used to pay for whatever you want, but you may have to give Uncle Sam his portion first. Generally, capital gains are taxed at a lower rate if you owned the appreciating asset (such as stocks and bonds) for more than a year (long-term gain). If, however, you sell the asset for a profit in less than a year (short-term gain), the tax rate jumps up to your regular income tax rate. With the sale of real estate, you may be exempt from capital gains taxes on profits totaling up to $250,000 for single homeowners, and up to $500,000 for married homeowners who file a joint tax return, as long as you meet the ownership and use test.
  
  

Ownership and Use Test

• To meet the ownership and use criteria, you must have owned the home for at least two years of the previous five-year period that ends on the date of sale (ownership), and you must have lived in the home as your primary residence for at least two years (use.) No limit is placed on the number of times you can use this capital gains tax exemption on the sale of real estate, as long as the criteria are met. By and large, you will be able to use capital gains from real estate (up to $250,000 or $500,000) to pay off a second mortgage on another home, take a dream vacation or invest for retirement, without owing Uncle Sam a dime.
  
  

Pro-Rated Exemption

• Even if you are ineligible under the ownership and use criteria, you may qualify for a pro-rated or reduced exemption amount under certain circumstances. If the sale or exchange of your property is due to a job change (more than 50 miles away), health issues or other unforeseen circumstances, such as an act of terrorism or a natural disaster, you may be able to claim a reduced exemption. For example, if you are married and bought a house in November 2009, and you had to sell the house in May of 2010 due to job relocation, your available capital gains tax exclusion would be $125,000 (6 months divided by 12 months, then multiplied by $500,000).
  
  

Investment Properties/Second Residences

• Unfortunately, the same tax break does not apply to investment properties or vacation homes. However, you can turn a rental property or second home into your primary residence. If you own and live in the home for a minimum of two years out of the five years leading to the date of sale, you can qualify for the capital gains tax exemption, although at a reduced amount. The two years of use and ownership do not have to be consecutive and you can decide which two years to count.