Particularly if you’ve owned your home for a long time, your primary residence might be your most profitable asset. While there have been periods of ups and downs over the last 20 years, median home prices in the United States have increased by 240%. If you are getting ready to sell your home, you could be looking to make a tidy profit. However, that also means that you are about to owe Uncle Sam a large chunk of change in the form of capital gains taxes.
Luckily, there are some ways to minimize, defer, or even avoid having to pay capital gains taxes at the time that you sell your primary residence. First, let’s review what capital gains taxes are and then the strategies and requirements for legally reducing that tax burden.
The Basics of Capital Gains Taxes
In real estate, a capital gain is the difference between the selling price of your home and the basis–or the price you bought it for, plus certain qualifying costs. To calculate your basis, you add the price you bought your home for and the applicable selling fees, such as the real estate agent commissions, the escrow fees, and title fees.
Let’s say the basis for a home you bought 15 years ago is $150,000. If you sell your home for $800,000, your capital gains would be $800,000 minus $150,000, or $650,000.
Capital gains taxes are the taxes levied on any profit made on assets. In this case, the profit you make from selling your home. Capital gains are classified as long-term or short-term and are taxed at different rates. Long-term capital gains are profits made on assets held for over a year, and they are given preferential tax treatment.
Long-term capital gains taxes are between 15%-20% depending on your income bracket. Many states also levy an additional capital gains tax as well. Therefore, if you make a $650,000 profit selling your home, you would potentially owe $130,000 in federal capital gains taxes alone.
Now that we understand what capital gains taxes are, let’s talk about ways to reduce how much you may owe right away.
Section 121 Exclusion
The Section 121 exclusion refers to the section of the IRS code that allows homeowners to exclude a portion of their capital gains when filing their taxes. Homeowners have to meet certain ownership and use requirements in order to be eligible, and there are limits on how much capital gain you can exclude.
If you are filing as an individual, you may exclude up to $250,000 of what you owe in capital gains. Married couples filing jointly may exclude up to $500,000 in capital gains when selling their primary home.
Eligibility Requirements
In order to qualify for the section 121 exclusion, homeowners must meet two key requirements: ownership and use.
Ownership: You must have owned the home for at least two years in the five years leading up to the sale. The two years do not have to be concurrent.
Use: The property must have been your primary residence for at least two years in the five years prior to the sale. Investment properties do not qualify for the 121 exclusion. However, the two years do not have to be consecutive, and they don’t have to immediately precede the sale.
There are a few other considerations that could disqualify you from using the exclusion. For example, if you have claimed this tax exemption within two years of your current sale, you are ineligible from using the exemption again.
If you don’t meet the two-year eligibility requirements, you might still qualify for excluding at least a portion of your sale if you have had a change in the workplace, a health-related incident, or an unforeseeable event. Active duty military members are not subject to the residency rule either. It is important that you work with a qualified tax advisor to be sure you are eligible to use the exclusion.
Reporting to the IRS
You have to report any profit beyond the exclusion amount (or if you don’t qualify for the exclusion) to the IRS on Schedule D (Form 1040) as a capital gain. Make sure you notify your realtor when you are selling your house so they can provide proof you qualify for the exclusion and provide the correct documentation.
Other Strategies for Reducing or Deferring Capital Gains Taxes on Property
If you don’t qualify for the Section 121 exclusion or you have capital gains in excess of the exclusion limits, there are other ways to reduce or defer those taxes.
1031 Exchange
If the property you own doesn’t qualify for the 121 exclusion because you don’t meet the residency requirements, you might be able to use a 1031 exchange. A 1031 exchange is a way for investors to exchange like-kind investment properties while deferring capital gains taxes. This strategy can only be done with investment properties, and the IRS limits its use with vacation properties. After selling your home, you must find and purchase a like-kind property within 180 days in order to qualify for tax deferment. If you can meet the qualifications, the 1031 exchange allows you to continue investing in real estate while deferring paying capital gains taxes.
Harvest Capital Losses
Capital gains are the profits made when you sell an appreciated asset. Capital losses are the losses you accrue when you sell an asset for less than you purchased it for. The IRS allows you to deduct up to $3,000 of capital losses from your taxable gains. So, if you have some underperforming assets in your portfolio, it might be smart to harvest those losses in a year when you are realizing significant capital gains. This will allow you to offset your gains with losses and reduce your overall tax liability.
Deferred Sales Trust
If you are selling a highly appreciated home and are going to be making more than $1 million in capital gains, it is worth looking into a Deferred Sales Trust as a way of deferring your capital gains taxes. Deferred Sales Trusts allow you to sell an asset and then retain the proceeds in a business trust, with the option to receive the funds in a series of installment payments over time. If you structure the trust to repay you through interest-only payments, you will only owe income tax on those payments. However, if the installment payments include both interest and principal, capital gains taxes will be owed on the principal portion received.
Deferred Sales Trusts work like this: you sell your asset to an independent third-party trust in exchange for a promissory note. The trust simultaneously sells to the buyer and takes possession of the proceeds. Because you didn’t receive any profit, you don’t owe any capital gains taxes. The trust then reinvests your proceeds and begins to repay you in installments as outlined in the promissory note. Although you will owe capital gains taxes on installment payments that include principal, you have successfully deferred and possibly reduced your overall tax liability.
If you are selling a primary residence and your capital gains are well over the $500,000 exclusion, you are probably asking yourself how you can defer capital gains taxes without a 1031 exchange. Primary home sales don’t qualify for the 1031 exchange, and you might feel stuck with a large tax bill from the government. A Deferred Sales Trust could be your answer. While they are simple in concept, they do require the help of a professional tax attorney and Deferred Sales Trust trustee, so reach out if you are interested.
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Infographic
The Section 121 exclusion allows homeowners to exclude some capital gains when filing taxes, provided they meet specific ownership and use requirements. If you don’t qualify or exceed these limits, other ways exist to reduce or defer taxes. Read on for more information in this infographic.
