Sell without paying capital gains tax?

A reader wants to know how they can sell their home without paying capital gains

Q: In 2020 my husband and I paid cash for a condo that my college son has lived in while going to school. He is about to graduate and get married. We are now contemplating selling the home. My spouse and I earn over $100,000 a year. We plan to use the profit from the sale of the home to purchase another property. Are we allowed to do so without paying long term capital gains?

A: The answer to your question depends on how you treated the condo. Was it an investment property that you rented to your son and perhaps his friends? Or, was it a second home that your son used during his college years?

What does it mean to treat the condo as an investment for tax purposes? You’d have rented it to your son, collected rent regularly and reported the ownership of the condo as an investment to the IRS. If that’s the case, you may have some options available to you that would allow you to defer paying any taxes on the sale of the condo.

On the other hand, if you simply purchased the condo as a second home for your son to use and never treated the condo as an investment, your options to avoid paying tax at this point are quite limited.

When second homes are sold, the IRS will require you to pay capital gains tax on the profits from the sale. In this case, you’d owe long-term capital gains tax, assuming you’ve owned the property for at least a year.

The tax treatment for second homes is completely different. Provided homeowners have lived in their home as a primary residence for two out of the last five years, the IRS allows them to keep up to $250,000 in profits per owner, or up to $500,000 for married couples.

Tax Breaks for Investors

But real estate investors do get some tax breaks from the IRS if they are selling an investment property. Let’s say you owned the condo for several years and treated it as an investment property during those years. Let’s further assume you collected rent from your son. On your annual tax returns you would have shown income, losses and depreciation from your ownership of the condo. When you made repairs or improvements to the condo, you’d have been able to write those off as well.

Avoiding Capital Gains Tax When Selling Investment Property

When real estate investors sell their properties, they may be able to use a provision of the IRS tax code that allows sellers of investment real estate to exchange the current investment property for a new investment property. Section 1031 of the IRS tax code, which is also known as a tax free exchange, gives you the ability to defer any taxes that you might have to pay on the sale of the investment property to a later date. But that benefit is conferred only after you’ve jumped through a few hoops.

First, you must sell the investment property through a special type of company that specializes in tax deferred exchanges. These companies are referred to as qualified intermediaries as they receive and hold the proceeds from the sale of your investment property. They then assist you in purchasing your replacement investment property. The funds being held are then used to close on the purchase of the new investment property.

Second, there are some stringent rules you must follow. In essence, you must have a contract to sell the investment property and engage 1031 intermediary company before you sell. The proceeds from the sale of your investment property must flow to the intermediary company. The cost of the new replacement property must equal or exceed the sales price of the original investment property. From the date of closing, you have 45 days to find and identify a replacement property that you would like to purchase. And, you must close on the purchase of that identified property no later than 180 days following the initial sale of the original investment property.

The timeline must be strictly followed. As do the myriad of other rules that make up that part of the tax code. However, if you follow them correctly, you can sell the old investment property, end up owning a replacement property, and defer the payment of federal taxes to some date in the future when you end up selling the replacement property.

What You Need to Know About Paying Taxes on a Home Sold After a Spouse’s Death

Or, in some cases, you won’t wind up paying any taxes if you die holding title to the replacement property and your heirs get the stepped-up basis at the time of your death. In other words, when you die, and if your estate is under the federal estate tax limit (currently $13,610,000 for the tax year 2024), your estate wouldn’t pay any estate taxes and your heirs would inherit the real estate investment at its value at the time of your death.

If your heirs then sell the investment property soon after your death, they, too, would pay no federal income taxes on that sale. Their basis in the investment property would be the value of the property when you died. The IRS would consider the sales price to be the value of the property at your death, even if your heirs sell the new property up to a year after your death.

As you can see, if you own the property as an investment and follow the 1031 exchange rules, you’ve got a solid option that will allow you to postpone paying capital gains tax.

But your options are more limited if the condo is a second home for your family. Here’s one option: keep the condo. Csonvert it into an investment property by renting it for several years. Then, you can sell it using a 1031 exchange and put the proceeds into a new property. Once you rent the property for two or more years, the property would officially become an investment property. That’s when the benefits of a 1031 exchange would kick in.

You’ll want to talk to a tax professional to go over the numbers as you might have to consider the sale down the line as part second home and part investment property. But, it still might save you some capital gains tax.

Personal Use Property Means You’ll Like Pay Capital Gains Tax

If you’ve decided to sell the condo so you can use the proceeds to buy something new that’s for personal use (either for yourselves or your son), you’ll likely pay taxes on any appreciation the condo has enjoyed. You’ll have to pay up to 23.8 percent in taxes to the federal government plus any state taxes due.

Your tax preparer might have other suggestions for you once they see how you’ve treated the property in the past and what other investments you have.


Sign up for Ilyce Glink’s free newsletter: Love, Money + Real Estate

©2024 by Ilyce Glink and Samuel J. Tamkin. Distributed by Tribune Content Agency. A1624