Strategies to Avoid Taxes on Property Sales
If you own a real estate property and plan to sell it soon, there are many strategies that can allow you to either lower your capital gains taxes or even completely eliminate the need to pay capital gains taxes. These benefits are available for anyone who wants to sell their personal property or investment property. While common methods such as tax loss harvesting and seller carryback can be useful for you, there are also ways for you to completely avoid paying capital gains taxes. This article will discuss how you can avoid paying capital gains taxes on your personal residence and/or investment property.
Home Tax Sales Exclusion
Many people may not be aware that you are eligible for a home tax sales exclusion of up to $250,000 according to current IRS regulations. If you are eligible for this benefit, you can use the tax savings for anything you want and are not required to make a specific type of investment to qualify. This can be a great way to lower your capital gains taxes and move more money into other types of investments.
According to the Taxpayer Relief Act of 1987, most homeowners are exempt from paying income taxes when they sell their homes.
Amount Eligible: Single applicants are able to exclude up to $250,000, which means you will not have to pay capital gains on up to $250,000 of the proceeds. For couples, this amount is $500,000.
Forms to Complete: Even though you may not have to pay any capital gains taxes on your home sale, you will still need to report this when you file taxes. You will still need to complete Form 1099 S, which provides information about the proceeds from your home sale.
Residency Rules: There are certain rules set in place to ensure that people do not exclusively use this for short-term purchases and for vacation or investment properties. According to the current rules, you have to prove that you lived in this home for two years out of a five-year period. Moreover, you are only eligible to use this tax benefit once every two years. If you have to move a lot for any reason, this can be a great incentive to help you avoid paying excess capital gains taxes when you move and sell a home.
Examples and More Points to Note
The 2-5 rule is pretty straightforward, but there are some important things to note to make sure you do not forfeit your eligibility for these tax savings.
Example: If you have been living in your home for over two years, and then decide to take a vacation to the Bahamas for 2-3 months, you will still be eligible.
Example: If you decide to take a sabbatical and live in Europe for one year, then this period does not count. It is best to talk to your accountant about how long you can be away and whether a trip is classified as a vacation or residency.
Example: If you live in your home for 1.5 years, move for one year and then come back for another year, then you are still eligible for this deduction. This is because the 2-5 rule states that you need to live in this home for two years out of a five-year window.
Cost Basis: Another important factor to note is that you can add the cost of any improvements that you made to your home to increase the cost basis. This is great news, as many homeowners make long-term investments in their homes, and many spend over $7,000/year on home improvements.
Example: If you purchase a home for $600,000, and then later sell it for $900,000, only $250,000 of this would be eligible for tax exclusion. You would normally have to pay capital gains taxes on the $50,000 above your cost basis. However, if you can show that you spent more than $50,000 on home improvements while residing in this home, you will not have to pay any capital gains taxes, as the gain will be below $250,000.
Notes on Short-Term Capital Gains: In general, it is best to avoid selling your house in less than 12 months, as any proceeds would be subject to higher short-term capital gains taxes. Moreover, you would not be able to exclude $250,000 of the capital gains, because you did not live in the house for more than two years. Short-term capital gains are taxed as ordinary income, so you could pay up to 37% in capital gains taxes.
Example: An investor in a higher tax bracket who sells his house for a $250,000 gain after living in the home for twelve months, would need to pay a 37% tax rate on the capital gains. Meanwhile, someone who lived in the home for three years and sold it for this same gain, would not need to pay any capital gains taxes.
Even if you can’t wait for over two years, and want to sell your home early, it is best to at least wait twelve months, as long-term capital gains are taxed at a lower rate.
Investment Property Sale
If you plan to sell an investment property, then there are many tax benefits available that can help you lower or even eliminate capital gains taxes. In most cases, a 1031 exchange is the best option, as it allows you to avoid paying capital gains taxes if you purchase another property.
This option is typically superior to other alternatives such as:
Tax harvesting: Investors can use losses from your stock portfolio or other investments to offset capital gains from a real estate sale. While this option is helpful, its impact is limited, and it is not guaranteed that everyone will have losses in their portfolio that they are willing to sell.
Convert to primary residence: If you convert the property into your primary residence, and live in it for two years, then you are eligible to exclude up to $250,000 in capital gains. You can do this once every two years, so if you have multiple rental properties, you could use this to your advantage if you are willing to live in these properties later.
Seller Carryback: You can act as a lender, and have your home buyer purchase the home and provide monthly payments. In this manner, you are gradually taxed at smaller amounts as the buyer makes payments, and do not have to worry about large, one-off capital gains taxes.
1031 Exchange is the best
While these three aforementioned strategies could be helpful, most real estate investors will find the 1031 exchange option to be their best bet if they want to sell their property and avoid capital gains taxes. A 1031 exchange allows investors to sell one investment property and replace it with a similar investment property. Doing this allows the investors to defer capital gains taxes and to have more cash to purchase the new property. This option is extremely convenient for investors who manage a portfolio of investment properties and may need to frequently sell properties due to changes in their investment style or other external macroeconomic factors.
Example: Suppose you want to sell one investment property for $400,000, in order to have more cash to buy another real estate property for $550,000. Without this tax benefit, most investors would have to pay a 15% capital gains tax on the property, which means that the investor would owe $60,000 in capital gains taxes after the sale. However, the 1031 exchange would allow the investor to pay 0% capital gains taxes, and to have the full $400,000 in proceeds to invest in the new property.
The Sale: One important factor to note is that you can’t receive the proceeds from the sale, as these proceeds need to be held in an escrow account.
Similar Properties: Another important thing to consider is that the IRS must consider the two properties to be similar in nature, which could be confusing for some investors. It is best to consult your attorney and to plan based on this regulation.
No Limits: Some of the previous tax benefits for residential investors, such as the $250,000 capital gains exemption, have some limits in place in terms of frequency. However, there is no limit on the number of times that you can use a 1031 exchange, which is very convenient for those who invest in a portfolio of properties.
Timeline: If you plan to take advantage of a 1031 exchange and are about to sell your home, it is crucial that you are ready to close on the new property quickly. You have 180 days to close on the new property, in order to be eligible for a 1031 exchange.
Reverse Exchange: In some cases, you may want to buy the new replacement property before selling your current investment property. Luckily, if you do this, the transfer will still be eligible for a 1031 exchange, and you will not have to pay capital gains.
Investors should also be mindful of depreciation recapture, which is a term to describe a case where an investor pays ordinary income taxes on depreciation from the previous property. In general, you can avoid this tax when you sell one property and purchase a similar one, but complex cases, such as purchasing a property with unimproved land, could trigger this tax.
Are Vacation Properties Eligible?
In some cases, you may be able to use a 1031 exchange if you sell your vacation home and exchange it for another similar property. However, you will need to rent out your property to tenants, even if it is just for a part of the year.
There are many ways for investors to lower or eliminate capital gains taxes when they decide to sell their investment or residential home. The process is a bit more complex for investment properties, especially if you choose to convert this into your residential home later, so it is best to talk with an accountant as early as possible to begin planning for this.
Categorised in: Planning, Real Estate
This post was written by Sean Allaband