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Real Estate Taxes: An Explainer
Real Estate Taxes: An Explainer
Real estate taxes and property taxes are two different types of tax.We’ll answer questions about how they’re different, what are real estate taxes and are real estate taxes deductible.
Table of contents
Key Takeaways:
- Real estate taxes are based on your home’s assessed value, while personal property taxes are for things like cars and boats.
- To avoid capital gains tax when selling property, you can use methods like the primary residence exclusion or a 1031 exchange.
- The real estate taxation calculation involves multiplying your home’s assessed value by the local tax rate.
What are real estate taxes?
So, what is real estate tax? They are yearly fees that homeowners pay based on the value of their property. Each city and state sets its own rules for determining how much you owe. They start by figuring out the fair market value of your home, then multiply that by a specific percentage set by your local government to get the tax assessment value. This value is used to calculate your real estate tax.
If you're selling property, you might also have to pay a real estate capital gains tax. This tax is on the profit you make if your property has increased in value. You’ll be taxed on the difference between the selling price and what you originally paid, minus any eligible deductions.
To know how to calculate real estate tax, you first need the assessed value of your home, which the government determines. Then, that value is multiplied by your local tax rate. For example, if your home is assessed at $200,000 and the tax rate is 1%, your yearly real estate tax would be $2,000.
Is real estate tax the same as property tax?
If you own a home, you’ve probably heard about real estate taxes. Many people even call them “property taxes,” and it’s easy to see why—most individuals use the terms interchangeably.
However, they’re not exactly the same thing. Real estate taxes are specific to the land and structures you own, like your home and are based on the assessed value determined by your local municipality. This is the amount you pay each year to support community infrastructures in your area.
Personal property taxes are a bit different. These taxes apply to moveable items you own (cars, boats, equipment, furniture). Real estate taxes also come into play when you sell your property, especially when considering the real estate capital gains tax.
This tax applies if you sell your home for more than you originally paid for it. While the real estate capital gains tax focuses on the profit you make from selling your property, the regular real estate taxes are what you pay annually based on the property’s value.
How to avoid capital gains tax on real estate
If you're trying to figure out how to avoid capital gains tax on real estate, there are some strategies that can make a big difference, and they’re easier than you might think. Let’s start with one of the most common methods: taking advantage of the primary residence exclusion.
Say you’ve lived in your home for at least two of the last five years before selling it. In that case, you can exclude up to $250,000 of the profit from real estate capital gains tax if you’re single, and up to $500,000 if you’re married.
For example, if you bought a home for $300,000 and sold it for $600,000 after living there for several years, you wouldn’t owe any capital gains tax on that $300,000 profit if you meet the residency requirement.
If you're dealing with an investment property, you can use a 1031 exchange which lets you defer paying real estate capital gains tax by reinvesting the money into another similar property. Say you sell a rental property and buy another one with the proceeds—you won’t have to pay capital gains taxes right away. This is a great move if you want to keep growing your investments without getting hit with a huge tax bill.
Another tip is to keep track of any major home improvements you’ve made. These can help increase your home’s cost basis, which in turn lowers your taxable gain. For example, if you spent $50,000 on a kitchen remodel or added a new deck, you can add that to what you originally paid for the home. When you sell, you’ll owe less in taxes because your profit appears smaller.
Finally, timing matters. If you hold onto your property for more than a year, you’ll benefit from the lower long-term capital gains tax rate, which can be much kinder to your wallet than the short-term rate. So, if you can wait, it might be worth it in the long run.
How to calculate real estate tax
Calculating real estate tax might sound tricky, but it’s really just a matter of knowing your property’s assessed value and your local tax rate. Imagine you own a home in a neighborhood where the tax assessor values your property at $350,000, even though its market value is closer to $400,000.
Local governments use the assessed value, not the market value, to determine how much real estate tax you’ll owe. Now, let’s say your city has a tax rate of 1.2%. To calculate your real estate tax, you simply multiply the assessed value of your home by the tax rate. So, in this case, $350,000 x 1.2% equals $4,200. That’s how much you’d owe in real estate taxes for the year.
It’s an annual cost, and many homeowners have it bundled into their monthly mortgage payment, so they pay it gradually. It’s also worth noting that while real estate tax is an annual obligation, real estate capital gains tax only comes into play when you sell your property. For example, if you bought that same home for $250,000 and sold it for $400,000, you may owe capital gains tax on the $150,000 profit, depending on how long you’ve owned the home and other factors.
Are real estate taxes deductible?
You might be wondering if real estate taxes are deductible, and the answer depends on a few factors. In many cases, you can deduct real estate taxes from your federal income tax return. This deduction can be especially useful for homeowners looking to reduce their taxable income.
To qualify, the real estate tax must be a local or state tax that’s assessed on your property’s value and paid to the appropriate government agency. For example, if you pay $3,000 in real estate taxes to your city or county, you can usually deduct that amount on your tax return. However, there are a few important points to keep in mind.
First, this deduction is subject to the limitations set by the Tax Cuts and Jobs Act, which caps the total amount of state and local tax deductions, including real estate taxes, at $10,000 per year. This means if your total state and local taxes exceed this amount, you won’t be able to deduct the excess.
Second, if you’re a real estate investor, you can also deduct real estate taxes related to your rental properties as part of your operating expenses, which can help lower your overall tax liability.
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