Can You Avoid Paying Capital Gains Tax by Buying Another House?

Can You Avoid Paying Capital Gains Tax by Buying Another House?

Posted by Clay Schmidt on Jul 21, 2022

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Selling a home for a profit can create a taxable event. If you generated a profit from the sale of your home, you could owe capital gains tax; however, some exclusions may apply. 

If you plan on buying another house, you have options that may reduce or eliminate your capital gains tax liability depending on whether the property is for personal use or if you plan to reinvest those funds into an investment property using a like-kind 1031 exchange. Here are some guidelines on when you might be liable to pay capital gains tax and when you may qualify for an exemption. 

What Is Capital Gains Tax?

Capital gains are the profits earned from selling an asset that has increased in value over the holding period. Assets can be tangible property such as real estate or personal property, or intangible property such as equity shares or intellectual property. If the investment is held for more than a year, it’s considered a long-term capital gain, which is taxed at a lower rate. Short-term capital gains – assets held for less than a year – are taxed as ordinary income. 

When these assets are sold or “realized,” it creates a taxable event that must be reported to the IRS, which will tax your gain on the sale of that asset. However, there are some exclusions when you sell your home.  

Capital Gains Tax Exemptions for Primary Residence

Your home is considered a capital asset and is subject to capital gains tax. If your home appreciates in value, you may be liable for capital gains tax. However, thanks to the Taxpayer Relief Act of 1997, you may be exempt.  

Here’s how you can qualify for a capital gains tax exemption on the sale of your primary residence: 

  1. You owned the home for at least two years 
  2. You lived in the home for at least two years 
  3. You haven’t claimed a capital gains exemption from sale of a primary residence within the last two years 

If you meet these requirements, you qualify for an exemption of $250,000 for single filing taxpayers and $500,000 for joint filers. 

Here’s an example: let’s say a married couple bought a home for $100,000 and used it as their primary residence for 10 years before deciding to sell. The house sold for $175,000, so their gain on the sale was $75,000. They would not be liable for any capital gains tax because they’ve met all the qualifying requirements and the gain was less than $500,000. The couple is free to use that income however they please. 

Completing a 1031 Exchange to Defer Capital Gains Taxes on an Investment Property

What if the home is not a primary residence and instead you had placed it in service as a rental to make passive income? You likely will generate a taxable event if you sell the property for more than your original investment basis, but there may be a way to defer any capital gains on the sale of an investment property. 

A 1031 exchange can help investors defer those gains, provided they roll the entire sale proceeds over into a like-kind replacement property. To qualify for a 1031 exchange, you need to follow the rules. Here’s a general qualifying checklist: 

  1. You own an investment property. 
  2. You wish to sell or exchange your investment property for a “like-kind” property.  
  3. You must follow specific rules and requirements. 

Here’s how a 1031 exchange can help you preserve capital upon the sale of an investment property, especially for highly appreciated assets that you have held for longer than one year: 

Straight sale 

Original basis: $500,000 

Sale price: $1.5 million  

Capital Gains Owed: 

$200,000 (20% of $1 million) 

Funds available for reinvestment: $1.3 million 

 

1031 Exchange Into a Like-Kind Asset 

Original basis: $500,000 

Sale price: $1.5 million  

Capital Gains 

Owed: $0 

Funds available for reinvestment: $1.5 million 

 

Note: The chart above uses the highest long-term capital gains rate, which is 20 percent. 

Want to know if you qualify for a 1031 exchange to defer capital gains tax? Plan ahead and make sure your exchange follows IRS guidelines. If your exchange doesn’t qualify, you might end up paying a hefty capital gains tax.

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Examples shown are for illustrative purposes only and do not reflect any fees or expenses that may be incurred during a real estate transaction. Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.

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