How to Avoid Capital Gains Tax on Real Estate
Selling your home or property should feel exciting, not stressful because of taxes. After all, selling real estate often brings in a lot of money that helps you move to your next home or investment. But capital gains taxes can be a big hurdle if you don’t understand how to handle them. Don’t worry! There are ways to avoid paying more taxes than needed, so you can keep more of your profit.
Let’s break it down step by step so you can make smart choices for your future and save money!
What is Capital Gains Tax?
Capital gains tax is a tax you pay when you make a profit from selling a property. This tax applies to homes you live in and investment properties. The good news is, there are legal ways to reduce or even avoid paying this tax.
Can You Avoid Capital Gains Tax on Real Estate?
Yes, you can! There are two main ways to avoid or delay paying capital gains tax when you sell real estate:
- The 121 Home Sale Exclusion: This helps homeowners who sell their primary home.
- The 1031 Like-Kind Exchange: This is for investors who want to sell one property and buy another.
Let’s explore these options in more detail.
What Is the 121 Home Sale Exclusion?
The 121 Home Sale Exclusion lets you avoid paying taxes on part of the profit from selling your main home. For example, if you live in a house like Brigade Citrine, and you sell it for a good profit, you may not have to pay tax on all of that profit.
How Does the 121 Home Sale Exclusion Work?
To qualify for this tax break, you need to meet a few requirements:
- Ownership and Use: You must have lived in the home for at least two out of the last five years.
- Exclusion Limits: If you’re single, you can exclude up to $250,000 in capital gains. If you’re married and file taxes together, you can exclude up to $500,000.
- How Often Can You Use It: You can use this exclusion once every two years.
What Types of Homes Qualify?
Many types of homes qualify for the 121 Exclusion, including:
- Mobile homes
- Trailers
- Houseboats
- Condominiums
- Single-family homes
Even homes in retirement communities qualify if you own a share of the property.
Special Exemptions for Unforeseen Circumstances
Sometimes, things happen that are out of your control, like a job transfer or health problems. If you had to sell your home because of these reasons and didn’t meet the two-year rule, you might still get a partial tax break.
If you or your spouse works in the military or government, you can extend the five-year rule to 10 years if you’re on extended official duty.
How Much Can You Save?
Let’s say you and your spouse bought a home like Brigade Citrine for $400,000 and made $100,000 in improvements. If you sell it for $1.2 million, your profit is $700,000. Thanks to the 121 Exclusion, you can exclude $500,000 of that profit from taxes if you file jointly. That means you only pay taxes on $200,000, saving you thousands of dollars.
What Is a 1031 Like-Kind Exchange?
If you’re a real estate investor, you can use the 1031 Like-Kind Exchange to defer paying capital gains taxes. This law allows you to sell an investment property and reinvest the money into another similar property without paying taxes right away.
How Does a 1031 Exchange Work?
Here’s how it works:
- Sell the property: You sell your investment property.
- Find a new property: You have 45 days to identify a similar property to buy.
- Use a Qualified Intermediary: You’ll need someone to hold the funds from the sale until you buy the new property.
- Buy the new property: You have 180 days to complete the purchase.
This way, you delay paying taxes on the profit from the sale until you sell the next property.
Example of a 1031 Exchange
Imagine you bought a building for $500,000, and now it’s worth $1.3 million. If you sell it, you would normally have to pay taxes on the $600,000 profit. But with a 1031 exchange, you can reinvest that $600,000 into another property without paying taxes immediately.
When Does a 1031 Exchange Not Apply?
A 1031 exchange only works for investment properties. You can’t use it for your primary home. Also, if you don’t follow the rules closely or miss the deadlines, you could lose the tax benefit.
Factors That Affect Capital Gains Tax
Several things can affect how much tax you’ll have to pay:
Income Level and Filing Status
Your income level and how you file your taxes (single, married, etc.) play a big role. For example, if you’re single and earn between $47,026 and $518,900 in 2024, you’ll pay 15% in capital gains tax.
Type of Property
If you sell your main home, you can get tax breaks like the 121 Exclusion. But if you sell a vacation home or rental property, you won’t get the same benefits.
How Long You Owned the Property
The longer you own a property, the lower your tax rate will be. If you sell a property after owning it for less than a year, you’ll pay short-term capital gains tax, which is usually higher. If you own the property for more than a year, you’ll pay long-term capital gains tax, which is lower.
FAQs About Avoiding Capital Gains Tax on Real Estate
How much is capital gains tax on real estate?
Capital gains tax can be as low as 0% or as high as 20%, depending on your income and the type of property you sell.
Can I avoid capital gains tax by reinvesting in another property?
Yes! You can defer capital gains taxes by using a 1031 Like-Kind Exchange when you sell one investment property and buy another.
How often can I use the 121 Exclusion?
You can use the 121 Home Sale Exclusion once every two years.
Do capital gains taxes apply to inherited properties?
Yes, but you may benefit from a step-up in basis, which adjusts the property’s value at the time you inherit it, potentially reducing the taxes you owe.
Conclusion: Make Smart Moves to Avoid Capital Gains Tax
Capital gains taxes can take a big bite out of your profit when you sell a home or investment property. But by using the 121 Home Sale Exclusion or the 1031 Like-Kind Exchange, you can keep more of your money. Whether you’re selling your main home or an investment property, these tax strategies can help you build wealth and save for the future.
So, the next time you’re thinking about selling your property—whether it’s a lovely home like Brigade Citrine or an investment building—be sure to use these tips to avoid or delay capital gains taxes. You’ll thank yourself later!
