All You Need to Know About Tax Exemptions When Selling Your Home
Selling your home can be quite a complicated process, especially when considering the various tax exemptions available to sellers. However, those exemptions may prove crucial to ensure you’re safeguarding your financial assets. After all, owning a home should be considered a prudent investment that you can cash out on.
In this article, we are going to examine two specific tax exemptions available to homeowners: a 1031 Tax-Deferred Exchange and the IRC Section 121 Exemption. As a homeowner, it’s important to know that these exist, as well as how they differ so you can make an informed decision as to which one is right for you. Of course, it’s always important to consult with experts, so please make sure to check in with your accountant or financial advisor prior to pursuing either one.
1031 Tax-Deferred Exchange
A 1031 Tax-Deferred Exchange gets its name from the IRS Code, Section 1031. Its purpose is to allow the seller of an investment property to defer paying capital gains. To do so, the seller must use the proceeds from the sale of their investment property to buy a replacement one. This tax exemption allows investors to keep upward of twenty percent of the appreciation on their current investment property, which they can then use to purchase another home with a better return prospect or as a means of diversifying assets.
One important note for consideration here is that this 1031 Tax-Deferred Exchange does not eliminate taxes on capital gains. Rather, it defers or delays the tax until you sell your investment property without purchasing a new one, at which time you will be required to pay capital gains taxes.
Here are some considerations to keep in mind if you’re thinking this may be relevant for you:
The property you are purchasing should be like-kind to your current property, meaning it should also be an investment property. According to the IRS, properties can be considered like-kind even if they differ in quality or grade, though primary residences do not qualify for this tax benefit.
To use the 1031 Tax Deferred Exchange, you must identify your replacement property in writing within 45 days of the sale of your last property, and you must acquire said property within 180 days.
A qualified, non-related third-party intermediary is required to facilitate the exchange.
There is no limit to how often or how many times you can take advantage of this tax exemption if you meet the requirements outlined above.
House flippers do qualify for this tax if they own the investment property for at least two years prior to selling it for a profit. While they are technically able to utilize this exemption, many do not because the price of the new home must always exceed the price of the last home sold. Given that house flipping makes use of lower-priced homes, this is not always possible or advantageous for home flippers.
If you are an investor and decide to convert your investment property into your primary residence, you will not meet the requirements for a 1031 Tax-Deferred Exchange and will be prompted to pay capital gains taxes. If you use the property as an investment for two years before converting it to a primary residence, you will end up with a transferred basis from the old investment property that you sold, which may trigger capital gains if the gain exceeds the threshold for tax exemption on primary residence sales ($250,000 if you’re single, $500,000 if you’re married).
IRC Section 121 Exemption
If you own a home but are not a property investor, this tax exemption will likely be the one you use. It allows a homeowner to exempt either $250,000 as an individual or $500,000 as a married couple in capital gains when selling their primary residence. To qualify, you need to live in the primary residence for two of the last five years. This means that even if you’ve been renting out your home for the last three years, you could still theoretically qualify if you lived in it the two years prior. Additionally, this clause allows you to take advantage of this exemption every two years if you move that frequently.
The only exception to this exemption occurs if you had previously purchased your property using the 1031 Tax-Deferred Exchange, which we mentioned above. This is because some people would utilize both tax exemptions to avoid paying capital gains taxes altogether, which the IRS grew wise to. If you previously exchanged into the property using the 1031 Tax-Deferred Exchange and want to make use of the IRC Section 121 Exemption because you’ve converted the investment property into your primary residence, you must own and live in the property as your primary residence for five years to qualify.
The bottom line here is that if you live in a property as your primary residence for two of the last five years, you can use this exemption and usually don’t need to use the 1031 Tax-Deferred Exchange.
Misconceptions & Myths
Lastly, we want to debunk some popular misconceptions related to selling your primary residence. When the Taxpayer Relief Act of 1997 became law, the following two tax laws related to real estate became obsolete, though many people still think they exist.
The first allowed a homeowner to avoid paying capital gains taxes altogether on their home-sale profit if they used the money to buy another, more expensive home within two years of the sale of their last residence. The second was referred to as a “once in a lifetime $125,000 exemption,” and it gave sellers aged fifty-five years or older the ability to use a once-in-a-lifetime tax exemption of up to $125,000 in profits. Despite both laws no longer existing, the IRC Section 121 Exchange and 1031 Tax-Deferred Exchange should grant you similar benefits and should be considered when selling property.
1031 Tax-Deferred Exchange Advisors
If you’re interested in learning more about these tax deferring strategies, please connect with us today.
*Thomas and Lee always advise our clients to seek individual consultations, as each person's situation can be unique. Please always seek advice from a professional. *