“For a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle.” Winston Churchill

If you sell your home and make a profit, you will pay taxes for the capital gains on your home sale if you can’t qualify for an exemption or defer paying taxes through a 1301 Exchange.

Capital gains are the profits you make from the sale of a capital asset, such as a home or stocks, according to the Internal Revenue Service (IRS). When selling your home, the amount of money you pocket after paying off your mortgage and related obligations is considered a capital gain. If you sell your home for less than it’s worth, then it’s considered a capital loss.

Two types of capital gains and losses…short-term and long-term.

• If you own the asset for less than a year, that profit is taxed as ordinary income or at your normal income tax rate. This is referred to as short-term capital gains.
• If you own the asset for more than a year. Instead of being taxed at your normal income tax rate, these profits are taxed at the lower tax rate for long-term capital gains.

Capital gains are considered income by the IRS and may be taxed. Short-term capital gains tax rates match standard income tax rates, while long-term capital gains tax rates vary by filing status and income. And, long-term capital gains tax are significantly lower than normal income tax rates.

Capital gains tax exemption

Capital gains of up to $250,000 ($500,000 for joint filers) on the sale of a principal residence may be excluded from gross income every two years.

You can sell your home and not pay capital gains tax based on rules in the 1997 Taxpayer Relief Act which exempted from taxation any capital gains on the sale of a primary residence.

For a capital gains tax exemption, you can exclude up to $250,000 of gain on the sale of your main home. Certain joint returns can exclude up to $500,000 of gain. You must meet all requirements to qualify for a capital gains tax exemption:

• You must have owned the home for a period of at least two years during the five years ending on the date of the sale.
• You must have used it as your main home for at least two years during the past five-year period after the sale or exchange.
• You can’t have used the exclusion for any home sold or exchanged during the two-year period. This period ends on the date of the current sale or exchange.

If you don’t qualify for the full capital gains tax exemption exclusion, you’ll be able to get a reduced exclusion with an exception. There’s an exception if all of these apply:

• You sold the home due to a change in employment.
• You didn’t meet the ownership and use tests.

This applies if you started work with a new employer or continue working with the same one in a different place. It also can mean the start or continuation of self-employment.

If the change occurred when you used the home as your main home, this can be considered the reason you sold your home. Your new place of employment must be at least 50 miles farther from your former home than was your former place of employment.

And, if you can exclude all of the gain, you do not need to report the sale on your tax return. If you have gain that cannot be excluded, it is taxable. Report it on Schedule D (Form 1040).

If you own multiple homes, you’re required to pay capital gains taxes on the sale of any home that isn’t your main residence. The act applies to only the dwelling that you consider your primary residence.

“Taxes are your largest single expense.” Robert Kiyosaki

Understanding capital gains exemptions for real estate

You may qualify to either fully or partially exclude the capital gains on your home sale from being taxed. Below, we break down the eligibility requirements for each exemption type.

IRS full exemption

You must meet the IRS eligibility test to be eligible for the full capital gains exemption on your home sale. The eligibility test requires you to meet the following requirements.

• Ownership. You must have been the owner of the property for at least two of the last five years. If you’re married, only one spouse needs to meet this requirement.
• Residence. You must have used the home as your primary residence for at least two of the last five years. The residency does not have to be completed consecutively, but both spouses must meet this requirement.
• Look-back. You must not have used the capital gains tax exemption on another home sale within the past two years.

Borrowers who meet these criteria may take advantage of the maximum exemption allowed by the IRS.

The 1031 Exchange.

One option to avoid paying taxes on capital gains is a “like-kind exchange” per Section 1031 of the tax code. In short version, you can take the proceeds from selling one property and use them to buy similar property, and defer paying the capital gains taxes on the sold property.

A “like-kind” property usually means a property used similarly. For example, you can sell a property used as rental property and use the profits to buy another property to be used as rental property.

There’s a time limit. Within 45 days of selling the original property, you have to “nominate”—identify to the IRS—the new replacement property you’ll be buying. Then, you have to actually buy it within a total of 180 days from when you sold the old property.

A 1031 exchange doesn’t mean you avoid paying taxes on your gains. When and if you ever sell the new property for a profit, you’ll owe capital gains taxes on it.

Once you sell the property, you’ll owe capital gains taxes on the property, unless you do another 1031 exchange, in which case you can keep buying higher-priced properties and keep deferring capital gains taxes indefinitely.

1031 Exchange Rules

If you plan to use a 1031 exchange, understand that there are some pretty strict rules that mus be followed. If you don’t, you won’t get the tax-deferred exchange.

1. Properties Must Be “Like-Kind”. The IRS requires that the property being sold and the replacement property must be “like-kind assets.” Also, keep in mind that the property must be an investment, not your primary or secondary home.
2. The Replacement Property Should Be of Equal or Greater Value. In order to completely avoid paying any taxes upon the sale of your investment property, the IRS requires that the replacement property being acquired is of equal or greater in value than the property being relinquished. And, the replacement property price must be greater than the sale price of the relinquished property, not just the profit you made.
3. 45-Day Identification Window. You must identify the property you plan to close on within 45 days or lose the entire benefit of the 1031 exchange. The timer doesn’t start until the day you sell your property.
4. The 180-Day Closing Window. The clock for the 45-day window starts ticking the moment the relinquished property is sold. At this same moment, another clock begins counting down. Its known as the 180-day closing window. The IRS requires that the new replacement property be fully purchased (the title officially transferred) within 180 days of the sale of the relinquished property. This rule, along with the 45-day rule, is strictly enforced. Your entire 1031 exchange will fail if you do not meet both rules.
5. Qualified intermediary. One of the most important rules governing the entire 1031 exchange process is that you must not touch the money of the sold property to avoid the taxes. Although there may be up to 180 days in between the sale of the sold property and the purchase of the replacement property, the proceeds may never enter your bank account or an account controlled by you. Instead, you are required to use a qualified intermediary who is someone who holds onto your money while you wait to buy the new property. A qualified intermediary cannot be you, your agent, your broker, your spouse, your family member, your investment banker, your employee, your business associate, or anyone who has had one of these roles in the past two years.

In summary, a 1031 exchange allows you to “defer” paying any property taxes on the investment property when it is sold, as long as another “like-kind” asset is purchased using the profit received.

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References:

1. https://www.msn.com/en-us/money/realestate/how-to-avoid-capital-gains-taxes-on-real-estate/ar-BB107jT3#:~:text=You%20could%20partially%20or%20fully%20avoid%20a%20capital,fall%20below%20the%20threshold%20for%20your%20filing%20status.
2. https://www.biggerpockets.com/blog/real-estate-investing-legally-avoid-capital-gains-taxes
3. https://www.biggerpockets.com/blog/2015-09-24-1031-exchanges-real-estate