If you own an investment property and are in the market to sell for a new property, you can defer taxes using the IRS tax code provisions. Depending on the type of property you own, you may qualify for a 1031 exchange or a section 121 exchange. Learn the differences between the two and how you can take advantage of both to potentially defer your capital gains taxes.
What Is a 1031 Exchange?
A 1031 exchange is a method for real estate investors to defer capital gains taxes on their real estate that is held for investment purposes. It allows investors to exchange the proceeds from the sale of their real estate for like-kind property that is equal or greater in value.
If the sale of an investment property leaves them with $250,000 in gains, they can defer the tax consequences by reinvesting the entire amount into another investment property. The like-kind property must be for investment purposes but doesn’t have to be the same type of property. For example, investors can sell a retail property and buy a rental home or apartment building. Investors also have flexibility when it comes to location. They can sell and buy property in different states and still be eligible for the 1031 exchange.
Like-kind property also includes exchanges of property for fractional ownership in a Delaware Statutory Trust (DST) or Tenants-in-Common (TIC). The 1031 exchange only applies to owners of investment properties and doesn’t cover people buying or selling their personal homes.
How Section 121 Differs
Section 121 of the U.S. tax code allows homeowners to defer capital gains from the sale of their primary residence. Taxpayers can defer up to $250,000 of gains from the sale of their home from their income. Married couples who file their taxes jointly can defer up to $500,000 of capital gains.
Taxpayers must meet both ownership and use tests to qualify for this exclusion. They must have owned and used the property as their primary residence for at least two of the past five years before the home is sold. Ownership and use of the house don’t have to coincide to meet eligibility requirements.
There are exceptions to this tax deferral. Taxpayers who exclude gains from the sale of another property within two years of the sale of their home are ineligible for Section 121.
Individuals or their spouses who are on extended duty for the U.S. Foreign Service, Uniformed Service, or the intelligence community can choose to suspend the five-year test period for a ten-year period instead.
To qualify for this exception, the individual must be stationed at least 50 miles from their primary residence and living in government housing.
Specifications to Keep in Mind
Whether you qualify for a 1031 Exchange or a Section 121 exclusion depends on the nature of your property and the timing of your sale. A 1031 exchange is only available to taxpayers with real estate property used for business or investment purposes.
To be eligible for this capital gains tax deferral, the entire proceeds from the sale of the investment property must be used. If you reinvest less than the full amount, it won’t qualify for a 1031 exchange, and you’ll have to pay the applicable taxes.
Taxpayers who own investment property and a primary residence can benefit from both a 1031 Exchange and Section 121 if they properly time the sale of their property.
Investors may want to sell their primary residence first or sell their investment property and primary residence further than two years apart to take advantage of tax deferrals.
