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.
The simplest way to avoid the capital gains tax is to live in the home for at least two of the five years immediately preceding the sale.
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.”
If you own the property within partnership, you cannot sell your interest in the partnership to avoid capital gains tax.
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.
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.