Making the decision to sell your home is a big deal. It allows you to walk into a brand new chapter of your life, which is definitely exciting. But that excitement doesn’t necessarily mitigate the anxiety you might have over making your home ready to sell, packing your things, and finding your next dream home. Plus, there is the added headache of taxes, that one universal thing that nobody likes dealing with.
The law requires that you must report a home sale to the IRS, but by doing this, you open up yourself to the possibility of incurring a heavy tax burden. Fortunately, there are ways to, at best avoid, and at worst minimize the taxes you might face after selling your home.
While there are two main methods worth mentioning, it is usually a good idea not to go through the process of selling your home or even trying to reduce the taxable amount without first consulting with a knowledgeable professional. Therefore, if you have the means to hire a real estate lawyer, the value and benefit to you will be immense. A good lawyer will be able to examine your entire situation and then determine and execute the best method to grant you the greatest level of tax reduction.
Options to Reduce Your Home Sale Tax Bill
Section 1031 Exchange
The first main method to avoiding having to pay a capital gains taxes on the sale of your home is called a Section 1031 exchange. Before we get into specific details it is important to help you understand the concept of capital gains. Capital gains refer to any amount of money or profit that you earn on the sale of the house or other property that is over and above the original purchase price. For example, if you purchased a home for $500,000, and sold it for $750,000, you would be experiencing $250,000 in capital gains, which then is taxable.
One thing to keep in mind is that this taxation happens on an adjusted basis. What this basically means or refers to is the actual value of your home which includes any and all investments you might have made to the home over time. So, if you purchased your home for $500,000, but invested a hundred thousand dollars into remodeling the kitchen, renovating the bathrooms, and re-paving the driveway, the actual value of your home would now be $600,000. Now, if you sold that home for $750,000, your capital gains are $150,000, instead of $250,000 previously referenced.
Keep in mind that these home investments do not include routine maintenance on the house, which will not be considered investments. Instead, the work done must add value to your home, prolong its lifespan, or add a different use to the home.
Back to the Section 1031 exchange. This part of the tax code allows for a real estate investment, and only a real estate investment, to be exchanged for an investment of like kind. Neither loss nor gain will be recognized until the new property is sold and the proceeds ‘pocketed.’
Essentially, if you sell your home for $500,000, and buy a new home for $500,000, there are no losses or gains, so you can avoid any capital gains tax as Section 1031 exchange will come into play. Keep in mind, this does not erase any taxes you ordinarily owe on your home sale, it simply postpones them, which can be a useful tool in many circumstances. The odds of you executing a perfect tax-free 1031 exchange are low, as the requirements are strict: I.e. the property must be of like kind, be used for the same purpose, be identified within 45 days, and be purchased within 6 months. As such, partially tax-free exchanges are much more common, and generally, involve one party kicking in an extra cash boot to maintain value. If you are a personal homeowner, and it seems like this exchange method works easier with businesses and real estate investments, don’t worry, there is another option.
There is a tax-break designed for homeowners, and it looks like this: if you have owned and lived in your home as your primary residence for at least 2 of the 5 years leading up the sale of your home, you may qualify for up to a quarter of a million dollars in tax-free profit. Additionally, this number could double if you are married and file the sale on a joint return. To qualify, all you have to do is meet the two-year primary-residence ownership requirement. The biggest thing to keep in mind with this is that you can’t use this exclusion more than one time in any two year period. If you’re planning on selling multiple homes within two years, you’ll have to figure out which home would generate more profit, and just pay taxes on the sale of the cheaper home.
While taxes are certainly the least exciting part of a home sale, there are definitive ways to reduce the taxes you might incur, and that is definitely exciting.