by Charissa Anderson, CFP®, CDFA
Portfolio and Wealth Management
When you sell real estate and make a profit, you may be taxed on that gain. When it comes to the sale, both how the property was used and the length of time you’ve owned the property will impact your taxation.
Below we break down the differences between the tax treatment of your primary residence compared to a vacation or investment property. We also cover potential strategies to mitigate the tax liability.
Primary Residence
You may exclude up to $250,000 in gains ($500,000 for married couples) if you have owned and lived in your home for two of the five years before the sale. These years do not have to be sequential.
To determine your gain, your cost basis must first be calculated. Your cost basis is the purchase price plus associated costs of purchasing the property (e.g., attorney fees, title insurance) and the cost of any improvements you have made, exclusive of maintenance and repairs. The difference between the sales price and your basis is your capital gain or loss. The amount of any debt on the property is irrelevant for this calculation.
Outside this $250,000 exclusion, the standard capital gains rules apply. If you own your home for less than one year, your capital gain is short-term, and you will be taxed at your ordinary income tax rate. If you own your home for more than one year, your capital gain above the exclusion is taxed at the more favorable long-term capital gains rates. The net investment income tax (NIIT) of 3.8% may also apply depending on your filing status and modified adjusted gross income.
If you own more than one home, you can only exclude the gain from the sale of your main home. Your main home is ordinarily the one you live in most of the time. However, while you may only have one main home at a time, you may have more than one during your lifetime. You can use the capital gains exclusion as many times as you qualify, although the exemption is only available once every two years.
While capital gains rules apply to the gain from your home, unfortunately the opposite is not true. You cannot claim a capital loss if you lose money on the sale of your home.
Investment Property
Like a primary residence, capital gains tax and NIIT apply to the sale of a rental property. However, rental properties and vacation homes do not benefit from the same capital gains exclusions as your main home.
In addition to being subjected to capital gains tax, investment properties are also subject to depreciation recapture. The IRS assumes your property wears out or depreciates over time. This depreciation is deducted on your tax return and is used to offset income. In addition to lowering your taxable income, depreciation also reduces the cost basis of your property. When you sell, the IRS recaptures your depreciation by requiring you to use this adjusted cost basis for calculating your gain, instead of your original purchase price. The amount of gain attributed to the depreciation deduction is generally taxed at your ordinary income tax rate, up to a maximum of 25% while the remaining profit is taxed at the capital gains rates.
Mitigating Taxes
There are several strategies available that may reduce the tax burden associated with the sale of real estate. Included below are some common strategies.
Offset Capital Gains with Capital Losses
If you have an investment that has an unrealized loss, you may sell that asset at a loss in the same year as the gain on your real estate. You may use capital losses to offset an unlimited amount of capital gains. If your losses are larger than your gains, you can offset your ordinary income by $3,000 with the remainder to be carried over for future tax years. There are netting rules when gains and losses include both long-term and short-term assets to be aware of, so coordination with your tax professional is important.
Installment Sale
If you own your property free and clear, you can use an installment sale to reduce the amount of tax owed when you sell the property. With installment sales, also known as a seller carryback or seller-financed loan, the buyer makes payments to the seller over time, rather than a lump sum at closing. This allows the seller to defer tax on a gain from the sale and possibly reduce the marginal tax brackets, and overall tax liability, by spreading it out over several years.
Turn the Property into a Primary Residence
By moving into a vacation or rental property, you may avoid tax on the future sale. To qualify for the personal residence exemption, the home must have served as your main home for at least two of the last five years. If the property was a rental, the law has additional limits on the amount you may exclude, and you may not exclude the part of your gain equal to any depreciation deduction allowed for periods after May 6, 1997. Furthermore, there are special rules regarding the exclusion if the property was acquired as part of a 1031 exchange.
1031 Exchange
Section 1031 of the Internal Revenue Code allows real estate investors who sell one investment property and purchase another like-kind property to defer paying tax on the sale. Properties are like-kind if they are of the same nature or character, even if they differ in grade or quality. This means there is a broad range of exchangeable real properties. For example, a single-family rental can be exchanged for a duplex, raw land or even a shopping center. These like-kind exchanges are generally only for investment properties; your main home or vacation house typically do not qualify. There is no limit on how many times you can do a 1031 exchange; you avoid paying tax until you eventually sell for cash.
1031 exchanges are complex and highly time sensitive. To ensure a smooth transaction, your professional team of advisors should include a qualified intermediary, knowledgeable real estate broker, attorney and tax professional.
If you do not want to have the ownership and management responsibilities of an investment property another solution may be a Delaware Statutory Trust (DST) 1031 Exchange program. A DST is a trust that allows fractional ownership in commercial real estate while qualifying as a like-kind real estate replacement property. After a holding period, this investment may get rolled into a shares of a diversified real estate investment trust (REIT). Ferguson Wellman and West Bearing have identified DST programs for clients interested in exploring this option.
Opportunity Zone
Created as part of the 2017 Tax Cuts and Jobs Act, an Opportunity Zone is an economically distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment.
Investors with short or long-term capital gains from the sale of any investment, including investment real estate, can defer the gain by investing some or all of the gain into a Qualified Opportunity Fund (QOF). You can defer paying taxes on your original capital gain until 2026. There are no capital gains on any additional appreciation if the investment is held for ten years or more. Also, in conforming states, no state level tax will be levied.
Ferguson Wellman and West Bearing have vetted and approved Qualified Opportunity Zone Funds for clients.
Charitable Remainder Trust
A charitable remainder trust (CRT) is an irrevocable trust typically funded with appreciated assets such as real estate. The CRT then sells the property and because it is tax-exempt, does not have to pay capital gains tax. In exchange, you receive an income stream from the trust for a term of years, or for life, and the named charity receives the remainder in value at the end of the trust term. In addition, you receive a current charitable tax deduction for the donation, but note the stream of payments you receive will likely include taxable income. CRTs may also reduce or eliminate estate tax as the assets contributed may be removed from your estate for estate tax purposes.
In Conclusion
Real estate tax laws can be complex and may change periodically. The laws also provide for special considerations, including divorce or military duty. Your Ferguson Wellman and West Bearing team is here as a resource but be sure to review these general concepts with your qualified tax advisors to determine how they may apply to your specific circumstances.
Ferguson Wellman, Octavia Group and West Bearing do not provide tax, legal, insurance or medical advice. This material has been prepared for general educational and informational purposes only and not as a substitute for qualified counsel. You should consult qualified professionals to understand how this information may, or may not, apply specifically to you.