Two big tax breaks you shouldn't overlook

  • Homeowners can exclude up to $500,000 from capital gains taxes on the sale of their home.
  • For certain small businesses, owners can exclude up to $10 million in gains.
  • The rules to qualify can be complex, so it's best to consult a tax professional.
Mature man carrying boxes to move into newly bought property
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There are many ways to reduce your tax burden. Two of the more lucrative ones these days are excluding gains from the sale of your primary home or from a stock sale of a business you own and operate.

The IRS permits capital gains from certain business stock sales to be excluded from federal tax. The catch: It only applies to qualified small business stock acquired after Sept. 27, 2010 that is held for more than five years.

Even better, the federal agency allows taxpayers to exclude up to $250,000 (or $500,000 for payers who file a joint return) of the gain from the sale or exchange of property owned and used as a principal residence for at least two of the five years before the sale.

Here's why that's so powerful as a tax-saving tool.

Traditionally, ordinary income (i.e., a paycheck) is taxed at rates ranging from 10 percent to 37 percent. Because rates are graduated, you won't pay the highest rate on your entire income. For example, you might pay 28 percent in federal taxes as a single earner on up to $191,650 in income, but a higher rate for income above that amount.

Long-term capital gains, on the other hand, have only three tax brackets: 0 percent, 15 percent or 20 percent. For many individuals, this tax tends to be in the 15 percent range. However, this also can vary widely depending on how much you earn. Either way, one thing is clear — long-term gains generally are taxed more favorably than ordinary income.

The process for determining whether you have a long-term capital gain is fairly straightforward. If you've owned an asset for more than a year and one day, long-term rates apply. If it's increased in value, then the gain will be taxed. If the asset has lost value, then a loss may be applied. The amount of gain or loss is determined by the amount you paid or "basis" for the asset.

A win for homeowners

A real estate agent shows a home for sale to a prospective buyer in Miami.
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A real estate agent shows a home for sale to a prospective buyer in Miami.

So, if you sell your house (and the price you got was more than you paid), this gain would generally be taxed at long-term capital gains rates.

However, the IRS allows any gain (up to $500,000 for married couples) from the sale of a primary residence to be excluded from long-term capital gains. This means that the entire gain from a home sale could be tax-free!

Still, there are some requirements that need to be met for the exclusion to apply. Your primary residence must have been used and owned for two of last five years. "Used" means the property was the taxpayer's main home, or the ordinary place of residence. "Owned" means the property belonged to the taxpayer and no one else.

If you are single, then the exclusion is reduced to $250,000. If married, the benefit surges to $500,000. These tests can get especially tricky if a taxpayer got married during this time or if the home was sold due to unforeseen circumstances, however. With that in mind, you may need to consult a tax advisor if your situation isn't cut and dry.

A break for small businesses

Small business owners who want to sell may be eligible for a break.
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Meanwhile, to encourage small-business development, the IRS has another incredible provision known as the "qualified small business" stock exclusion. In this case, up to $10 million in gains associated with the sale of a small business could be treated as tax-free income. In other words, a small business owner or owners could possibly sell their business and not pay any taxes on the gains!

There are certain requirements that need to be met for this one to apply, all of which are quite doable if you set the business up correctly.

First, the business must be owned for at least five years. During that time, the owner (or owners) has to be actively involved in the operation and management of the business. Sorry, passive business ownership is not allowed.

Second, during this five-year period, the business must also be set up as a C-corporation — even if it didn't start out as one. Third, ownership of the business must have begun at "original issue" — in other words, you owned the business when it first launched. If you are the sole owner, this is no big obstacle.

If there are multiple owners, it could be the case that the exclusion could apply to some but not all owners, depending on when each co-owner earned shares in the business.

Fourth, the gross assets of the business cannot exceed $50 million to qualify for this exclusion. And finally, your business cannot fall under any of the following umbrellas: personal or professional services (think doctor's office) or businesses within the banking, insurance, finance, farming, oil and gas, hotel or restaurant industries.

If you think you may qualify, make sure to consult with a tax advisor if you're planning on selling. The tax savings could be huge, making your time and effort well worth it.

— By Ben Martinek, president of Bona Fide Finance