Everyday investors are avoiding capital gains taxes by applying 2 IRS rules
AP Photo/Bill Sikes
- Selling a property for profit typically results in paying capital gains tax.
- But there are ways to defer or avoid capital gains tax altogether.
- If you own property, look into 1031 exchanges and the Section 121 exclusion.
If you sell a property for more than you purchased it for, you'll typically owe capital gains tax on the profit.
The amount depends on factors like how long you owned the property and your taxable income, but it could be as high as 37% if you sell within a year and trigger short-term capital gains.
You could also avoid capital gains tax completely. CPA Kristel Espinosa highlighted two IRS rules that all property owners looking to reduce their tax bill should familiarize themselves with.
1. Defer taxes indefinitely with a 1031 exchange
A 1031 exchange — sometimes called a "like-kind" exchange — allows investors to avoid capital gains tax if they swap one investment property for another one of equal or higher value. This rule is specifically for investment properties, not for primary residences or vacation homes.
"It's a way to defer capital gains by reinvesting the proceeds into a like-kind property," said Espinosa, noting that this strategy is best for investors who plan to buy and hold real estate for the long term.
"It's not meant for people who just want to purchase real estate, flip it real quick, and then get another one. The whole point is getting the gain to be deferred into the future, so if you're constantly buying and selling and flipping properties, this 1031 game doesn't work."
You'll pay capital gains tax when you sell for good — there's no limit to the number of 1031 exchanges you do — but you can theoretically avoid capital gains tax indefinitely if you continue re-investing in like-kind rentals.
Espinosa said her clients use this strategy to diversify their portfolio or upgrade to a property with better cash flow.
There's a strict time limit on 1031 exchanges: You must identify your replacement property (or properties) in writing within 45 days of selling the first property. Then you must close on the replacement property within 180 days of your initial property sale.
Investor Zeona McIntyre told BI how she used a 1031 exchange to upgrade from a small, short-term rental property in St. Louis to a multifamily in Florida that produced stronger cash flow.
Courtesy of Zeona McIntyre
"A 1031 exchange allows you to defer your tax burden; a lot of people think, 'Oh, I don't pay any taxes,' but you're technically kicking the can down the road," McIntyre said. "The cool thing, though, is that you can do unlimited 1031 exchanges and infinitely kick it down the road. And then when you pass away, if you pass that on to someone else, like your children or a family member, the inherited home does not have the tax burden anymore. So it dies with you."
Another investor spoke to BI about his attempted 1031 exchange that ultimately failed because of the tight 180-day timeline.
"In my opinion, that's not enough time. I felt like I was rushed," said Steve Lewis, who owns properties in New Jersey and ended up walking away from the exchange and paying capital gains tax on the sale.
His major takeaway was that 180 days go by faster than you may think. While his failed 1031 experience may be "rare," he said, "there are so many things that could delay a closing." If you plan to do an exchange, his advice is to plan ahead as much as you possibly can for the next property purchase.
2. Exclude up to $500,000 of the gain of a home sale with the 121 exclusion
If you're a homeowner looking to sell, you may benefit from the Section 121 Exclusion, an IRS rule that lets taxpayers exclude up to $250,000 of the gain from the sale. A couple filing jointly can exclude up to $500,000. If you're an individual and sell your home for a gain of $200,000, for example, you won't have to pay capital gains tax on that amount.
There are a few stipulations: You must use the home as your primary residence for at least two of the five years preceding the sale. If you're selling a vacation home, for example, you can't use the exclusion. You can also only use the exclusion every two years.
This rule won't be applicable to new homeowners, said Espinosa, but it's a good option for people who have been in their primary residence for years and are looking to sell — and even applies to people who have turned their primary residence into a rental, as long as they satisfy the two-out-of-five-year rule. The two years don't have to be consecutive.
If your home profits more than $250,000 as an individual or $500,000 as a couple, you'll pay capital gains tax on the amount that exceeds the limit.
Carl and Mindy Jensen
One couple explained to BI how they used the exclusion to avoid capital gains tax on each of their property sales. For years, Carl and Mindy Jensen did "live-in flips," in which they would live in a property while renovating it. They made sure to live in the property for at least two years to capitalize on the tax rule — at that point, they'd sell, avoid capital gains tax, and start their next live-in flip.
They used the exclusion for the first time in the early 2000s when they bought a home for $135,000, upgraded the carpet, walls, and bathrooms, and sold it for $235,000.
"Because we lived in it and owned it for two of the past five years, we paid no taxes on the capital gains," said Mindy. While their gains were around $100,000, they could have excluded up to $500,000 since they were both on the title.
"And then we did it again," she said. "We bought another house for $265,00 and sold it for $365,000, so we made another 100,000."
Thanks to the IRS rule, that $100,000 was also shielded from taxes.
