So, you’re saying that I should be worrying about capital gains tax on real estate? Indeed! You can avoid capital gains tax on real estate by investing and living in the same home. But how long do you need to live in a house before we can call it a second home? …You don’t want Uncle Sam taxing your gains.
As real estate investors, when we hold onto our properties for an extended period of time, capital gains tax becomes a real threat to the investment property business. Find out how to avoid capital gains tax on real estate
You probably know that, if you sell your home, you may exclude up to $250,000 of your capital gain from tax. For married couples filing jointly, the exclusion is $500,000. Also, unmarried people who jointly own a home and separately meet the tests described below can each exclude up to $250,000. Related Products
The law applies to sales after May 6, 1997. To claim the whole exclusion, you must have owned and lived in your home as your principal residence an aggregate of at least two of the five years before the sale (this is called the ownership and use test). You can claim the exclusion once every two years.
But, even if you don’t meet this test, you still may be entitled to a whole or partial tax break in certain circumstances.
Table of Contents
First, How Much Is Your Gain?
Many people mistakenly believe that their gain is simply the profit on the sale: “We bought it for $100,000 and sold it for $650,000, so that’s a $550,000 gain, and we’re $50,000 over the exclusion, right?”. It’s not so simple — a good thing, since the fine print can work to your benefit in such instances.
Your gain is actually your home’s selling price, minus deductible closing costs, selling costs, and your tax basis in the property. (Your basis is the original purchase price, plus purchase expenses, plus the cost of capital improvements, minus any depreciation and minus any casualty losses or insurance payments.)
Deductible closing costs include points or prepaid interest on your mortgage and your share of the prorated property taxes.
Examples of selling costs include real estate broker’s commissions, title insurance, legal fees, advertising costs, administrative costs, escrow fees, and inspection fees.
So, for example, if you and your spouse bought a house for $100,000 and sold for $650,000, but you’d added $20,000 in home improvements, spent $5,000 fixing the place up for the sale, and paid the real estate brokers at least $25,000, the exclusion plus those costs would mean you’d owe no capital gains tax at all.
Splitting Up Big Gains
If you expect huge gains from selling a house — more than can be excluded from tax — you should consider ways to divide ownership of the house.
For example, say a couple owns their residence together with their adult son (perhaps because they’ve given him a share). If he meets the ownership and use tests as to one-third of the property, the son may sell his share for a $250,000 gain without incurring a tax. His parents could simultaneously sell their share for $500,000 without tax, sheltering the entire $750,000 gain.
Managing the Sale Date
You could mitigate this tax burden by controlling the year in which title and possession passes out of your hands and, therefore, the year in which you report the capital gain on the transaction. In other words, you can set the transfer of ownership to a year in which you expect to have a lower tax burden.
According to the Internal Revenue Service (IRS), “some or all net capital gain may be taxed at 0% if your taxable income is less than $80,000.” Therefore, if you have no active income and minimal passive income, including the gain on the sale of your investment property, you may avoid paying taxes on your minimal capital gain. However, if your income is steady and paying tax on the gain looks inevitable, you may want to consider using the IRC Section 1031 exchange.2
The Section 1031 Exchange
The IRS Code Section 1031 exchange allows an investor to trade real estate held for investment for other investment real estate and incur no immediate tax liability. Under Section 1031, if you exchange business or investment property solely for a business or investment property of a like-kind, no gain or loss is recognized until the newly acquired property is sold.1
Beginning in 2018, The Tax Cuts and Jobs Act limited like-kind exchanges to real estate. Section 1031 exchanges of personal property, such as artwork, are no longer permitted.3 1
Rules and Regulations
IRS Code Section 1031 will not allow the avoidance of capital gains taxes in all cases. For example, the exchange of U.S. real estate for real estate in another country will not qualify for tax-deferred exchange status. Furthermore, trades involving property used for personal purposes—such as exchanging a personal residence for a rental property—will not receive tax-deferred treatment. Finally, if an exchange is made between related parties and either party subsequently disposes of the exchanged property within a two-year period, the exchanged property will become subject to tax. 4
For tax reporting purposes, the basis of the old property is carried over to the new property. This is important to understand because the taxes due are not forgiven, they are simply postponed until the sale of the new property. 4 To record the Section 1031 exchange with the Internal Revenue Service, it is important to file Form 8824 with the tax return for the year of the like-kind exchange, as well as for each of the two years following the exchange. 5
Section 1031 and Losses
A tax-deferred exchange is also possible if you are selling your investment property at a loss. First, you must determine if the loss is a “tax loss” or just a personal loss. In order to qualify as a tax loss, your adjusted basis in the property must be more than the selling price of the property. Your adjusted basis takes into consideration any prior depreciation deductions you have taken (or were allowed but didn’t take).6
For example, let’s assume you bought a rental property for $400,000. Over the past ten years, you have taken $100,000 of depreciation on the building. Your current adjusted basis is $300,000. If you sell your rental property for $350,000, it may seem like a loss, but it is actually a $50,000 gain for tax purposes. The gain is considered an unrecaptured section 1250 gain, and it is taxed at a rate of 25%. However, you could purchase a “like-kind” property in order to avoid paying taxes immediately on your $50,000 gain.
Alternatively, let’s assume that you are selling the same home for $250,000. This is a $50,000 tax loss, in addition to a personal loss. Is there still a benefit to a “like-kind” exchange? Possibly. If you purchase a “like-kind” property for $250,000, your basis in that second property will immediately be $300,000 (your adjusted basis in the first property).4 This would benefit you when it comes time to sell the second property, because the basis you are taking depreciation deductions from is higher.
Fully Tax-Deferred Exchange
For a tax-deferred Section 1031 exchange transaction to occur, certain conditions must be met:
- The property must be “like-kind”: Properties are like-kind if they are of the same nature or character, even if they differ in grade or quality.
- The property must be related to business or investment: Exchanged property must be held for productive business or investment use and traded for the same use. For example, an exchanged property must not be primarily held for resale.
- The new property must be identified within 45 days: The new property to be received in exchange for an existing property must be identified in writing, to the seller, within 45 days of the first transfer.
- The transfer must take place within the 180-day window: The like-kind property must be received by one of these two dates (whichever comes sooner): within the 180-day period following the property transfer, or by the tax return due date (including extensions) for the year in which the property is transferred. 5
Partially Tax-Deferred Exchange
To be completely tax-deferred, the exchange must be solely an exchange of like-kind property. In a perfect world, finding a property with the same trade value is ideal for the Section 1031 exchange. However, it’s difficult to find an equal exchange and, in many cases, one party ends up kicking in some extra cash to make the deal fair. This additional property or cash received is known as “boot,” and this gain is taxed up to the amount of the boot received.7
When there are mortgages on both properties, the mortgages are netted. The party giving up the larger mortgage and receiving the smaller mortgage treats the excess as boot.
Health Savings Accounts
HSAs are one of the few accounts where you can receive a tax deduction for contributing to them, invest them and receive tax free growth and then not pay any taxes as long as you use withdrawals for qualified health expenses. Investing your HSA account to receive tax free growth is another way to avoid paying the capital gains tax.
However, all of the tax-advantaged accounts just described are further paperwork at the end of the day. No real economic value is gained from this complicated shuffle of assets, even though you clearly benefit by retaining more of your assets.
Gift to charity
Instead of giving cash to the charities you support, you can give appreciated stock. You receive the same tax deduction. When the charity sells the stock, it is not subject to any capital gains tax. The cash you would have given is the same amount you would have had for selling the stock and paying no capital gains yourself.
Buy and hold
Many investors buy good index funds that never need to be sold. Even if you rebalance regularly, rebalancing can often be accomplished by using the interest and dividends paid to purchase whichever investments need to be bolstered. The downside is that your capital is locked inside the investment vehicles and not free to be used for greater economic gain.
Conclusion
If you buy and sell real estate but you’ve never sold property before, good for you–because you’ve got a whole lot to learn! Sales tax is much less than capital gains tax because it’s not nearly as much paperwork to pay it. And if you’re buying and selling multiple properties, the capital gains tax work will quickly add up to more than any profits that might be associated with it. Capital gains taxes are still an amount much smaller than you’ll pay in state and federal income taxes.