Q: On Ilyce’s radio show, I heard her suggest that if you’re moving to a new location you should rent for a year before making a house purchase. This would give the renters the opportunity to search out different areas, and make a more knowledgeable location decision.
That sounds smart. My question is how long does a person have before taxes must be paid on the profit from the sale of the previous home, and would these profits be considered capital gains by the IRS?
Also, if a person rents past that period of grace, what percentage of tax will be required from the previous sale? What is your suggestion for parking that sale profit for a few years before another house purchase?
A: You should know that in general, the sale of a home is independent of the purchase of a new home. Years ago, you had to buy a replacement home to avoid paying capital gains taxes on the profits from the sale. It was called the “rollover replacement rule,” and for some reason, many people still think it exists.
Today, if you sell a home and your profit is less than $250,000 if you’re single or less than $500,000 if you are married, you pay no taxes on your profits, or gains as long as you’ve lived in the home as your primary residence for two of the last five years. If your profits exceed these limits, you’d owe long-term capital gains tax if you owned the home for at least 12 months, or you’d have to pay taxes at your marginal tax rate if you own the home for less than 12 months.
That means you could sell your home and know immediately whether or not you would owe any taxes. It doesn’t matter what you do after the sale with the proceeds: You can buy another home, rent or move in with someone else.
If you’re in the process of selling a home now, you should feel free to move forward with that sale even if you have not found a new home to move into. In this real estate market, it might be better for a seller to sell even if the seller hasn’t found a suitable replacement home.
To accurately calculate the profit on your home sale, you might have to do a little work. The “cost basis” of the property is the price you paid for your home, minus the cost of sale. You should also adjust that number to include the costs of capital improvements made to the home while you lived there.
IRS Publication 523 (available for free at IRS.gov) gives examples on how to compute the “cost basis” for your home.
If you’re selling an investment property, you should know that you may owe taxes on the profit from the sale and on the recapture of depreciation taken over time on the property.
To defer the payment of taxes on the sale of an investment property, the seller must use a mechanism called a 1031 exchange on the sale to then select a replacement property to purchase within a certain amount of time. If you follow the strict rules of a 1031 exchange, you will defer paying any taxes on the sale of that property until any replacement property is sold and you don’t then defer the taxes again using a 1031 exchange.
These exchanges are also called like-kind exchanges or Starker trust exchanges. But remember, these exchanges are reserved for investment properties and not for primary residences or second homes.
To summarize, if you own your home and it’s your primary residence and you sell it, you won’t have to pay taxes on the profits from sale of your home if: (i) the home was your primary residence, (ii) you lived in the home for two out of the last five years, and (iii) your profits do not exceed $250,000 if you are single, or $500,000 if you are married and filing jointly. If your property has lost value and you have a loss, you can’t deduct the losses from the sale of you primary residence.
While a down real estate market may mean you may not have profits, when the market returns and you do have profits from the sale of your home, you most likely won’t have to pay any federal income taxes or capital gains taxes to the internal revenue service. Lastly, remember the profit on your home is the difference between what you paid for the home, plus any improvements you put into the home, and the sales price, less costs of the purchase and sale of the home.
If your property is a commercial or investment property, you can defer the payment of federal income and capital gains taxes by using a 1031 exchange. When you sell the old property, you’ll have to go through the technicalities of replacing that property within 180 days of the sale and using the 1031 exchange mechanism.
For more articles on capital gains taxes on real estate and using a 1031 exchange, read more of our articles: