Although two things in life are certain – death and taxes – there are important ways to avoid or defer the latter. As property values continue to appreciate, owners may find that their current home has significantly appreciated while they have outgrown the need for their larger home. Such owners may be able to avoid or defer significant capital gains taxes by utilizing both a Section 121 exclusion and a Section 1031 deferred exchange.
In a Section 121 exclusion, generally, a taxpayer may exclude $250,000 gain ($500,000 if married filing jointly) when calculating your capital gain upon sale if you lived in the home as your main home for at least 2 of the last 5 years before the date of sale. In a 1031 exchange, generally, a taxpayer may exchange an investment property for like-kind investment property and defer the payment of taxes. IRS Bulletin 2005-7, https://www.irs.gov/irb/2005-07_IRB/ar10.html, allows a taxpayer to combine both tax avoidance and deferral methods.
Let’s look at an example: The taxpayer and taxpayer’s spouse purchased a home in 1990 for $100,000 and lived in the home continuously until 2014, when they sold it for $1,100,000. The couple would have a total gain of $1,000,000 and a taxable gain (assuming they qualify for a Section 121 exclusion) of $500,000. Thus, they would be responsible for capital gains tax on $500,000. There are other elements to calculate and raise basis and thus lower taxable gain not considered here.
Now, let’s look at an example where the taxpayers can avoid and defer all taxes: The taxpayer and taxpayer’s spouse purchased a home in 1990 for $100,000 and lived in the home continuously until 2014, at which time they moved out of the home and rented it to a disinterested party at fair market rent. They rented the property until 2016 when they sold the property for $1,100,000. The couple would have a total gain of $1,000,000 and a taxable gain (assuming they qualify for a Section 121 exclusion) of $500,000. If the couple successfully completed a Section 1031 deferred exchange by purchasing a replacement investment property, the couple would avoid payment of capital gains taxes on the $500,000 in gain.
The sweet spot for the combination Section 121 exclusion and Section 1031 deferred exchange is between the second and third year of moving out of the home. Any more than three years will eliminate the opportunity for a Section 121 exclusion. Any less than two years will potentially disqualify the Section 1031 deferred exchange.
The above scenario is complicated and representative only. Please consult your legal counsel and tax advisor for the careful planning necessary to utilize these tax strategies.
Esquire Real Estate provides both a real estate attorney and real estate broker for all of your property needs and can advise you on the necessary steps to accomplish this combination Section 121 exclusion and Section 1031 deferred exchange.