If you’re planning to sell an investment property or your own home this year, it’s important to be aware of the potential impact capital gains tax could have on your bottom line. Otherwise, you could end up with less money than you thought to put toward your next real estate purchase or another financial goal.
Fortunately, there are strategies that can enable sellers to avoid capital gains tax on real estate, either by legally deferring or avoiding paying taxes altogether on their real estate gains. Read on for some basic info on how the capital gains tax works and how you might be able to minimize the tax burden after a successful sale.
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Understanding Capital Gains Tax on Real Estate
Selling a piece of real estate for more than you paid is usually something to celebrate — but don’t party too hard just yet. If the value of the property has increased substantially, you may have to make a hefty payment to the IRS to cover the capital gains tax on your profit.
The amount you might be taxed on your sale can depend on a few different details, including how long you owned the property, if it was your primary residence when you sold it, how much you made on the sale, and your household income that year. Here are some factors to consider:
Short-Term vs. Long-Term Capital Gains
The length of time you owned the property before selling it will determine whether your profit is a short-term or long-term capital gain. That could make a significant difference in how, and how much, it’s taxed — as well as in how to avoid capital gains tax on real estate sales.
• If you sell the property after owning it for only a year or less, for example, the profit is considered a short-term capital gain, and you’ll be taxed at your ordinary income tax rate for the year you made the sale.
• If you sell after holding the property for more than a year, on the other hand, the profit is considered a long-term capital gain, which makes it subject to preferential capital gains tax rates.
Long-Term Capital Gains Tax Rates
Whether you’re selling your primary residence or an appreciated investment property, the tax rate (0%, 15%, or 20%) that applies to your long-term capital gain will be based on your taxable income and filing status that year. Here’s what the rates look like for 2024:
| Filing Status | 0% | 15% | 20% |
|---|---|---|---|
| Single | Taxable income up to $47,025 | $47,026 to $518,000 | Over $518,000 |
| Head of Household | Taxable income up to $63,000 | $63,001 to $551,350 | Over $551,350 |
| Married Filing Jointly/ Surviving Spouse |
Taxable income up to $94,050 | $94,051 to $583,750 | Over $583,750 |
| Married Filing Separately | Taxable income up to $47,025 | $47,026 to $291,850 | Over $291,850 |
Potential Exemptions
Before you start calculating (and stressing out about) what you might owe, however, it’s important to note there are exemptions that might help you reduce or even avoid paying taxes on your capital gains. These include the “home sale exclusion,” which can be used by homeowners who are selling their primary residence, and the “1031 exchange,” which allows investors to defer the taxes on a real estate sale by reinvesting their profit into a similar property. Here’s a look at how each strategy might benefit you, depending on your specific circumstances.
Deferring Capital Gains Tax with a 1031 Exchange
A 1031 exchange (named for Section 1031 of the Internal Revenue Code) allows those who invest in real estate to defer the tax obligation on a property they’ve sold by using the proceeds to replace it with a similar, or “like-kind,” property. This is how it works:
Qualifying for a 1031 Exchange
The property used as a replacement in a 1031 exchange must meet three basic requirements:
• It must be a long-term investment. The property can’t be a quick “flip.” And it can’t be your personal home.
• It must generate income while you own it through rental or some other use. You can’t buy the property and just hold onto it with a plan to sell it later.
• It must be of the same “character and class” as the property it’s replacing. The replacement property doesn’t necessarily have to be used for the same purpose as the one that’s been sold, though. As long as both properties are used as investment properties that earn income, they generally can qualify as a like-kind exchange.
Deadlines and Rules
You can make a direct swap with another property owner to complete a like-kind exchange — if you can find the right property for your purposes. More often, though, sellers use a qualified intermediary (QI) to facilitate a “delayed” exchange. With this type of transaction, proceeds from the sale of your original property go directly to the QI to hold in escrow, and you must find and purchase a replacement property within a preset timeline following two main deadlines:
• The 45-Day Rule: Within 45 days of closing on the original property, you must designate a replacement property — or properties — in writing to the QI; and
• The 180-Day Rule: You must close on the new property within 180 days of selling the original property.
These two periods run concurrently, so you may want to find a real estate agent who can help you locate a new property before you complete the sale of the old one. Make sure you’re familiar with how to get a mortgage loan and the different types of mortgage loans before you begin the process of closing on the original property, and line up a home mortgage loan for the new property, should you need one.
Reverse Exchanges
You also may choose to do a reverse exchange, using those same 45- and 180-day deadlines, and still qualify for the 1031 tax deferral. In this case, you would transfer a qualifying replacement property to an intermediary, identify a property you already own that you want to sell, and complete the sale within 180 days of closing on the new property.
Reporting a 1031 Exchange to the IRS
You must notify the IRS of the 1031 exchange by submitting Form 8824 with your tax return for the year the exchange took place. It’s important to hold on to financial documents and keep good records, including descriptions of the properties involved, closing dates, and other details of the transaction. (Because this can be a complicated process to complete and report, you may want to consult with a tax professional before proceeding.)
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Saving on Taxes with the Home Sale Exclusion
Investors aren’t the only ones who can benefit from a tax break when selling a property for a profit. A tax provision known as the Section 121 Exclusion, or “home sale exclusion” allows homeowners who meet specific requirements to exclude up to $250,000 (or up to $500,000 for married couples filing jointly) of capital gains from the sale of their primary residence. Here are some basics that can help you determine if you qualify.
Ownership and Use Tests
To use the home sale exclusion, you typically must meet these requirements:
• You must have owned and used the home as your primary residence for at least two of the five years leading up to the date of the sale. The two years don’t have to be consecutive.
• The home must qualify as your primary residence. For example, it should be the address used on state and federal IDs, voter registration, filing taxes, and utility bills. And you can only claim this exclusion once every two years.
Calculating the Taxable Gain
Here’s an example of how the home sale exclusion might work. Let’s say, Joe, who is single, buys a house for $200,000 and sells it three years later for $500,000. His profit is $300,000; but after applying his $250,000 exclusion, Joe would pay capital gains tax on only $50,000 of the profit.
Depending on what Joe’s taxable income is in the year he makes the sale, he could pay a capital gains tax rate of 0%, 15%, or 20% on this reduced amount.
Other Strategies to Minimize Capital Gains Tax
The 1031 exchange and home sale exclusion are two popular methods for minimizing the tax on real estate capital gains. But there are other strategies you may also want to consider to reduce the tax blow to your bottom line.
Installment Sales
If you make a large profit on your property sale and want to spread out your capital gains tax liability over a period of several years, you may want to look at the benefits of receiving installment payments from the buyer instead of a lump sum. With this method, you would pay capital gains tax only on the portion of the gain you receive each year until the property is paid off.
Let’s say you’re an older couple hoping to sell your home and downsize to a less expensive home purchase or a rental in retirement. Or maybe you’re a young couple planning to sell your home in a high-priced city in order to move to a less expensive location so one of you can stop working and stay home with the kids. An installment sale would allow you to reduce your upfront tax burden and could provide a reliable income stream when you make this big life change.
Tax-Loss Harvesting
Tax-loss harvesting is another popular option for reducing long-term capital gains. Here’s an example of how it might work:
Let’s say you made a big profit on a real estate deal, but you also suffered a large loss on a long-term investment held in a taxable investment account. You may be able to use (or “harvest”) that loss to offset some of the gains from your successful property sale. Or, if you have long-term investments that aren’t doing as well as you’d like, you might choose to sell them for less than you paid and use the loss to help offset your taxable gain.
If it turns out your loss is more than your gains, you also may be able to reduce your ordinary income by up to $3,000 in that tax year. And you can carry forward any remaining loss — up to $3,000 per year — to future tax years.)
Charitable Donations of Real Estate
If your list of financial goals includes charitable giving, donating real estate directly to a qualifying charitable organization — instead of selling it, paying capital gains tax, and then donating the profits — could help you maximize the amount of your gift. You also may be able to claim a tax deduction equal to the fair market value of the property during the tax year when the gift was made, which could significantly reduce your tax burden. With this strategy, both you and your favorite charity could benefit.
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Planning for Capital Gains Tax in Real Estate Investing
Navigating capital gains tax in real estate can be complex, which means planning is a must. Here are a few things to keep in mind whether you’re hoping to sell a property (or properties) this year or in the future.
Record-Keeping and Cost Basis
One of the best ways to reduce your capital gains tax is to make the most of all the reductions the IRS allows. But you’ll have to back up any costs you claim. So holding on to financial documents you receive while you own the property is imperative — including the original closing documents from your purchase, receipts from any major improvements you made, the real estate purchase contract and the closing documents from the sale. As a general rule, it’s smart to track home-improvement costs for any materials and labor that increase the value of the property (in other words, not general upkeep expenses).
This information will help you determine your property’s cost basis (or adjusted cost basis if you made major improvements), which is the value that will be assigned to your home or real estate investment for tax purposes.
Seeking Professional Advice
Another way to make sure you’re getting every tax break you can when you sell your property is to work with a financial professional who’s experienced in real estate taxation. This could help you keep more of your money after the sale and avoid making a misstep that could lead to an expensive IRS penalty.
The Takeaway
Understanding how to avoid capital gains on real estate, and doing some proactive planning, could make a big difference to the bottom line of a successful property sale. And the more money you can keep in your own pocket, the more you’ll have to put toward your other financial goals — including buying your next home or investment property.
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FAQ>
What qualifies as a like-kind property for a 1031 exchange?
A “like-kind” exchange doesn’t mean the old and new properties have to be exactly the same size or in the same neighborhood. But the net market value and equity of the replacement property must be the same as, or greater than, the property that’s been sold — and it must be in the U.S. The properties also should have a similar purpose (selling one rental property and acquiring another, for example).
Are there any time limits for 1031 exchanges?
Yes, there are two main deadlines you’re required to meet to successfully complete a 1031 exchange. First, within 45 days of closing on the original property, you must designate at least one replacement property in writing to a qualified intermediary. Next, you must close on the replacement property within 180 days of selling on the original property. These two time periods run concurrently.
Can you use a 1031 exchange for a primary residence?
A primary residence typically doesn’t qualify for a 1031 exchange. The properties involved must be used as an investment or for business.
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