There’s nothing wrong with using profits to pay down debt. That simple transaction reduces leverage. But is it possible to pay down debt using capital gains, and are there any tax advantages to this tactic?
Selling a primary residence comes with special tax treatment. This is called the Section 121 exclusion or primary residence tax exclusion. If you have lived at least 2 of the past 5 years in your primary home, gains on the sale are not taxed.
Section 121 allows up to $250,000 in gains for single filers ($500,000 for married couples filing taxes jointly) to be excluded from taxation.
These gains can be used to pay off debt or for any other use. The use of the excluded gains will not affect the tax status of those gains. Once the home sale has been made, the transaction is complete, and so is the Section 121 exclusion. Using gains from the sale is a completely separate transaction.
Without the Section 121 exclusion, are there any other methods for real estate gains to avoid taxation while paying off debt? Unfortunately, no. Gains from the sale of a rental property will be taxed at short or long-term capital gains rates depending on the holding period.
Of course, an investor can always do a 1031 exchange and defer taxes on their property's gains. However, funds will be tied up in the replacement property and unavailable to pay off debt.
If money is leftover (i.e., boot) from a 1031 exchange, it will generally be taxed at capital gains rates. From there, the funds can be used for any purpose, including paying off debt.
What about capital gains on the sale of stocks? There is no taxable offset from gains on the sale of stock for paying down debt. The two are separate transactions. Once stock sell gains are taxed, the funds can be used for any reason.
Investors should consult with their tax specialists when trying to use capital gains in some tax-advantaged scenarios. Each person's tax situation is different, and in some cases, general tax explanations may not apply to specific cases.