First, the bad news. The IRS levies a capital gains tax of up to 15 percent, depending on your tax bracket, on the profitable sale of investment property. Furthermore, investment property does not normally qualify for the capital gains tax exclusion on up to $250,000 in capital gains ($500,000 for married couples filing jointly) that personal residences typically enjoy.
That exclusion’s worth a pretty good chunk of change. Assuming the top long-term capital gains rate of 15 percent, that adds up to as much as $37,500 for single owners, and double that for married couples. That’s enough to warrant doing some tax planning to mitigate the tax hit. You may not be able to avoid it altogether, but you may be able to take the edge off of the bill.
Know the Capital Gains Tax Rules
The good news is that once you rent a property out, it is not forever doomed to be treated like an investment property, subject to capital gains taxes on the first dollar. You can convert a property’s status from an investment property to a personal residence by satisfying the IRS’s simple use test: To claim the exemption, you must have lived in the property for at least two years out of the preceding five.
The simplest way to avoid the capital gains tax, then, is to live in the home for at least two of the five years immediately preceding the sale.
Use Section 1031 Exchange
The “landed gentry” has occupied a place in Congress since the dawn of the Republic. It’s not surprising, then, that they would write a landlord-friendly provision or two into the tax code. In fact, Congress has given real estate investors a gift not normally available to retail investors in stocks, bonds and mutual funds: a deferral of capital gains tax on exchanges of one property of “like kind” for another. For example, you can sell a residential rental property and buy a new one in exchange, under Section 1031.
To qualify, the property you’re selling and the property you’re buying must be of “like kind.” They don’t have to be identical – they just have to be in the U.S., and serving approximately the same function in your overall portfolio. Generally, you can exchange U.S. real property for another U.S. real property and defer capital gains tax under section 1031.
What Qualifies for Capital Gains Tax Deferral Under Section 1031?
There are some special rules that apply. The two properties don’t have to change hands at the same time, as would be the case with a direct swap, says the IRS. Instead, with a deferred exchange, “the disposition of the relinquished property and acquisition of the replacement property must be mutually dependent parts of an integrated transaction constituting an exchange of property.”
Additionally, you can’t defer capital gains in a personal residence under Section 1031. Both of the properties must be business or investment properties. Vacation homes don’t count. This provision only defers capital gains on one property. Your tax basis in the old property transfers to the new one.
Careful – Section 1031 only applies to the property itself. If you own the property within partnership, you cannot sell your interest in the partnership to avoid capital gains tax.
How Long Do I Have to Execute a 1031 Deferred Like-Kind Exchange?
There are two time limits you need to worry about: You have to identify your new property, in writing, within 45 days of selling the old one. You also have to deliver your identifying document to an intermediary whose function is to ensure that the 1031 exchanges are actually realized. “Notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient,” warns the Internal Revenue Service.
Second, you have only 180 days after the sale to complete the acquisition of the new property, or until the due date of your income tax return, including all extensions. If you blow either deadline, plan on paying the entire capital gains tax. The IRS does not grant waivers to these timelines, except for presidentially-declared disasters.
For more information on like-kind exchanges under Section 1031, see IRS Publication 544.
Sell a Loser
If you have investment property to sell at a profit, potentially generating a capital gains tax liability, look to see if you have any investments that have lost money. If you do, you may be able to offset some or all of your capital gains tax, using a technique called “tax loss harvesting.” The IRS aggregates all your gains and losses for the year. So selling losers can help you lower your capital gains tax bill. Furthermore, if you have excess losses, you can deduct up to $3,000 from your income, and carry this loss forward every year, deducting your loss against any capital gains, and then up to $3,000 of ordinary income, until your losses are exhausted.
Time the Sale
If you must pay the capital gains tax, consider doing so when your income is low. Why? Because your capital gains tax is a function of your income tax bracket. The lower your taxable income, the lower your long-term capital gains tax is likely to be.
For that reason, the best time to sell a property you’ve been renting is when your net taxable income, after deductions, is abnormally low. Try to bunch deductions in the same year, and shift income out of the year.
Use a Deferred Sales Trust
If you are unable to find a suitable like-kind property, or execute the transaction in time to qualify under Section 1031, or you simply want to get out of real estate, you may consider establishing a deferred sales trust (DST). The buyer funds an annuity held within the trust. The trust sends the income stream to you, according to a schedule that suits your income needs. This allows you to defer capital gains tax by taking your sales proceeds in the form of installment payments, in what the IRS deems a “structured sale” under IRC Section 453. You only pay the capital gains tax gradually, as you receive the payments from the trust.
Enlist!
Five years not enough? Join the military! If you are on active duty, and you are called away from your home on orders from Uncle Sam, you can “stop the clock” on the IRS’s use test for up to 10 years. Short of that 10-year limit, the IRS does not penalize members of the military for being called away from their homes of record on military orders. However, if this provision applies, you must still have lived in the property for at least two years of the previous 10 years to qualify. However, you cannot use this provision more than once every two years.
{ 23 comments… read them below or add one }
My husband and I have dual primary residences. His job in Philadelphia, lives in our Downingtown, Pa, I was relocated to Tustin, Ca with my job and my daughter and i live in our Southern Ca home. We file jointed married. When we sell one of our home what happens with capital gains?
Please advise
I was divorced a year ago and in my divorce papers it states that if my exhusband sells the property I am to get half. My question is did he find a loop hole in the paper work by renting the property out. If so what should I do?
Kimberly Goodwater
Hi Jason,
Thanks for the information–very helpful. I do have a question though. I have a rental house that I’m looking at moving back into (was my primary residence) after about 4 years of renting to satisfy the 2 of last 5 rule, then sell. I’m thinking of either selling my current residence (a condo) or renting it out for the couple of years while I live in my house, then basically sell both of them around the same time. I’m not interested in doing a 1031 exchange. I understand the last 2 out of 5 year rule, but read somewhere you can only do this on one property every 2 years. If I rent my condo would I then be subject to capital gains on it if I sell it in a couple of years, having lived here for three years prior? I guess my question is can I do this on both properties if I technically qualify for the 2 of last 5 year rule? Thanks!
Hi. We built a house in 2005 and had to leave it due to job transfer. WE have rented it out since then, but at a loss every month! We just tried to keep it from going into foreclosure, but we continually lost money. WE now have someone interested in buying. Will we pay capital gains? I have all the receipts we paid to build the home (pre-rental income receipts) that total more than we are selling it for, but some of the receipts have faded. The person interested in purchasing is wanting to do a lease option and pay us money over three years to apply to the principal and wants us applying to our mortgage. Technically, that money is closing money, but if it is given two years or more before the closing do I have to count it as income now or just wait and count it when we do actually close?
I have a question about this gray area phrase that is used “The simplest way to avoid the capital gains tax, then, is to live in the home for at least two of the five years immediately preceding the sale.” What does that mean? Does that imply that you have to have lived in the home in the the IMMEDIATE two years before you sell it? We have owned the home for 15 years,and just starting renting it out. In a black in white answer, how long can we rent it without paying the capitol gains? We won’t have lived in it for the IMMEDIATE two years before the sale. But we will have lived in it for 2 of the 5 years that we owned it. Pls help with a simple answer that seems to have alot of gray area’s.
Hello, Debbie, and thanks for writing! There are a couple of special situations where different rules apply, such as where the homeowner is active duty military. But for most folks, to qualify for the full capital gains exemption, you have to meet a two-pronged test, called the ‘ownership and use’ test. 1.) You have to have owned the home for two of the past five years, and 2.) You have to lived in the home for at least two of the five years immediately preceding the sale. There’s no requirement that it has to be the last two years. It can be any two years. Furthermore, you can’t have excluded the gain from the sale of another home in the previous two years. See http://www.irs.gov/publications/p523/ar02.html#en_US_2012_publink1000200713 All the best, and thanks for reading,
Jason
I’m almost past the two out of five year time-frame. If I sell to a friend at a very low price within time frame, and then later buy back from this friend, does the two out of five year time-frame start all over again?
In other words, if I miss this time=frame, then when I do sell, will I have to pay capital gains tax?
If my income is low, does that mean you do not have to pay capital gain tax? Thanks for your response
Hello, Ruby…
Remember, there are two tests… you have to have lived in the home for two years of the last five, and you have to have owned the home for two of the past five years. The clock doesn’t ‘reset.’ The IRS looks at the five rolling years prior to the sale. Remember that you can’t exclude gains more than once every two years. Jason
We bought a fourplex last year to live in and rent the others. In other words owner occupied. In the middle of the process we got a military order to move overseas for 3 years and we had to move after living there for 3 months.
We realized the property had gained some value and now we are planning on selling it. We intend to move back to this place when we go back to Washington. If I sell this house now, do I need to pay capital gains tax at 15 percent as a rental house? Or is there a military waiver?
Please email me your expert solution
I sold a rental and made 100k which I invested into another new rental property five years ago. If I sell my new rental and lose 50K do I owe any capital gains tax?
thanks,
Randy
I am selling my rental property and buying another rental property that I would eventually like to live at. In order to not pay capital gains tax, how long must my new property be a rental before it becomes my primary residence ?
I have the same question. And using the 1031 helps but it limits the amount of time you have to find another property and we also have a lot of repair costs on the one we are selling that we would like to use some of the monies from the sale to pay for. Also what is the % to pay on capital gains? 5-15%. That is a big jump, I could do 5% but not the 15%.
I rented out my home for 7 years…. never lived there during the 7 years. Can I take the money and apply it to the mortgage of two rent houses I already have and not pay the capital gain tax?
Hello, Debbie, and thanks for writing.
Doubtful. Under the Section 1031 like kind exchange rules, you have to EXCHANGE one rental property for another. Selling it and applying the proceeds to pay off homes you already own is not an exchange, just a sale.
To lower your capital gains tax, you can sell other assets that you’ve lost money on… thereby employing a “tax-loss harvesting” strategy (You can Google around on that term for more information) or simply execute a Section 1031 exchange. Or simply keep on renting and let your tenants pay the mortgages on the other two properties.
Have a great day!
Jason
If a rental property is owned by 2 individual people, and 1 person has lived in the residence for 2 years out of the five preceding years PRIOR To the rental and 2 years out of the five preceding the sale of the property, is capital gains tax eliminated from both owners?
I have the same question.
And what if an owner has a renter while they are living there as their primary residence?
Anyone?
I have a house that was my primary for 15 years, but I had to move as I changed jobs. The problem was that the home is in Phoenix and the market has been (and still is so bad I had to rent the property. So now I’m past the two out of five year time-frame. But it was Job related. Will the IRS exemption on the 2 out of five year work in this case?
Thanks
Chuck
I’m in the same situation. Is there any forgivness from IRS do to job related transfer. Avoid paying the capital gain if I sale in Calif.. Otherwise, I’d have to move back into my rental in California for the next two years and rent my home in Nv.
bought new home how long can i rent old home without paying capital gains taxes
I own a home that I’ve lived in for 16yrs; leaving due to the death of my husband and my own very serious health problems. I still own the home but I’ve rented it for a few weeks seasonally. Probably four weeks in 2012. I paid $226K. Now I can sell it for between $500K and $600K. I have done considerable work and repairs on the house in upkeep and preparation for either renting or selling – a new roof was installed 6yrs ago, I will have a sewer assessment of around $5K due – the realtor fees, painting throughout, carpet cleaning, etc. Where can I go for answers to my obligations? I am 82yrs old.
Hi Carolyn,
It’s so nice to finally start hearing about homeowners with equity in their homes!
That said, I don’t understand what you’re looking for when you say “answers to my obligations.” If you can clarify that and let us know what questions you have we’d be happy to help.
Shannon – 1. Do I still get the $250K credit, even though I have rented the house for a few weeks? I have not lived in the house for any part of the past 5yrs. Just a couple of months each year. It is impossible for me to move back to NC due to my declining health and inability to live alone. Many surgeries have left me with “foot drop” and neuropathy in my feet and legs. The continuing expenses make it financially tight, thus trying the rental route to help out.
We added a burglar alarm and boat life when we were building the house. We also added length and other amenities at a later date. I would guess about 5yrs after we moved in.
Do that answer your question? When you reply, please notify me at seaknott@gmail.com
People had better take advantage of all the tax benefits they can from their homes before they evaporate !