When a property is sold, it creates a taxable event. If you profited from its sale, you’re on the hook for capital gains tax; however, some exclusions may apply.
When you’re buying another house, there are options to 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 with a like-kind 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?
A capital gain is the profit earned from the sale of an asset that has increased in value over the holding period. An asset can be tangible property such as real property and personal property or intangible property such as 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 are held for less than a year and are taxed as ordinary income.
When these assets are sold or “realized,” it creates a taxable event that must be reported to the IRS. The IRS will then tax your gain on the sale of that asset. When it comes to homes, there are exclusions if you qualify.
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. Thanks to the Taxpayer Relief Act of 1997, you may be exempt.
Here’s how you can qualify for capital gains tax exemption on your primary residence:
- You’ve owned the home for at least two years
- You’ve lived in the home for at least two years
- You haven’t exempted the gains on a home sale within the last two years
If you’ve met these requirements, how much you can exclude depends on your filing status. For a single-filer, the amount is up to $250,000 and for joint filers, the amount is up to $500,000.
Here’s an example: let’s say a married couple bought a home for $100,000 as their primary residence and lived in it 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 capital gains tax as they’ve met all the requirements and the gain was less than $500,000. The couple is free to use that income however they please.
The 1031 Exchange
What if it’s not a primary residence? What if it’s property that you use as a rental to make passive income? If you structure your transaction as a 1031 exchange with an investment property, you can defer your capital gains tax liability.
To qualify for a 1031 exchange, you need to follow the rules. Here’s a general qualifying checklist:
- You own an investment property.
- You wish to sell or exchange your investment property for a “like kind” property.
- You must follow specific rules and requirements.
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.