When Do You Pay Capital Gains Tax on Property Sale?

When Do You Pay Capital Gains Tax on Property Sale?

  • 06/11/24

Question: Do I need to purchase another home after I sell my current home to avoid paying taxes?


Answer: I often talk with people who conflate two different real estate tax concepts – the capital gains exemption and the 1031 exchange. A misunderstanding of these two very different concepts can lead to improper planning and avoidable mistakes so I’ll spend this week’s column helping you understand the difference.


One is for Primary Residence, One is for Investment Properties

The most basic difference is that the capital gains exemption applies specifically to the sale of a current or former (see details below for former) primary residence and the 1031 exchange applies specifically to the sale of an investment property.


One Requires the Purchase of Another Property, One Does Not

I often hear people mix-up what they have to do with the proceeds of a real estate sale to qualify for the tax benefit. To benefit from a 1031 exchange (investment property) you must purchase another like-kind investment property soon after the sale is completed. The benefits of the capital gains exemption are earned at the time of the sale, regardless of what you do with the proceeds or if you ever buy another property again.


Capital Gains Exemption on the Sale of a Primary Residence

The capital gains exemption allows homeowners to exclude a significant amount of profit from the sale of their primary residence. For single filers, up to $250,000 of capital gains can be excluded. For married couples filing jointly, the exclusion amount doubles to $500,000. The gain is calculated by subtracting your cost basis for the property (original purchase price, capital improvements, selling costs) from the sale price.


Qualifying Criteria:

  • Ownership/Use Test: The home must have been your primary residence for at least two out of the last five years before the sale. These years do not need to be consecutive. In practice, that means that if you decide to rent your home after moving out, you’ll lose the capital gains exemption if you rent for 3+ years.
  • Frequency: This benefit can be claimed once every two years.


Special Considerations:

  • Partial Exclusion: If you don’t meet the full criteria for the ownership/use tests, you might still qualify for a partial exclusion under certain circumstances, such as a change in employment, health issues, or unforeseen circumstances.
  • Home Office Deduction: If you’ve claimed a home office deduction, you’ll need to account for that portion of your home’s value separately when calculating your gain.
  • Improvements and Selling Costs: Keep records of any home improvements and selling costs, as these can be added to your cost basis, reducing your capital gain.


1031 Exchange on the Sale of an Investment Property

While the capital gains exemption is for primary residences, the 1031 exchange is a powerful tool for real estate investors. Named after Section 1031 of the Internal Revenue Code, this strategy allows investors to defer paying capital gains taxes on investment properties when they reinvest the proceeds into a like-kind property.


Qualifying Criteria:

  • Like-Kind Property: The properties involved in the exchange must be of like-kind, which generally means they are both investment or business properties. The definition of like-kind is quite broad, allowing for flexibility in the types of properties exchanged.
  • Timing:
    • Identification Period: You must identify potential replacement properties within 45 days of selling your original property.
    • Exchange Period: The purchase of the replacement property must be completed within 180 days of the sale.
  • Use of Intermediary: You must use a qualified intermediary to handle the transaction. This intermediary facilitates the exchange by holding the proceeds from the sale of the original property and using them to purchase the replacement property.


Special Considerations:

  • Depreciation Recapture: When you eventually sell the replacement property without another 1031 exchange, you will owe taxes on the depreciation taken on the original property.
  • Higher Basis: By deferring taxes, your basis in the new property will be lower, which could result in higher capital gains taxes when you sell it in the future.
  • Estate Planning: Heirs can benefit from a stepped-up basis to the market value at the time of the owner’s death, potentially eliminating the deferred gains.


Consult a Tax Professional

It’s important to consult with a tax professional to ensure you understand the tax implications or benefits of keeping or selling property, especially during or after significant life events like a divorce or death. A tax professional can provide tailored advice and help you navigate these complex rules, ensuring you make the most financially advantageous decisions.

If you’d like to discuss buying, selling, investing, or renting, don’t hesitate to reach out to me at [email protected].

If you’d like a question answered in my weekly column or to discuss buying, selling, renting, or investing, please send an email to [email protected]. To read any of my older posts, visit the blog section of my website at EliResidential.com. Call me directly at (703) 539-2529.

Video summaries of some articles can be found on YouTube on the Eli Residential channel.

Eli Tucker is a licensed Realtor in Virginia, Washington DC, and Maryland with RLAH Real Estate, 4040 N Fairfax Dr #10C Arlington VA 22203. (703) 390-9460.


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