Do You Have to Pay Capital Gains if You Reinvest in Another House?

When it comes to selling real estate, understanding capital gains tax is crucial for homeowners and investors alike. Capital gains tax is the tax imposed on the profit made from the sale of a property or investment. However, many people wonder whether reinvesting that profit into another house can exempt them from this tax. Let's find out in this article.

What is Capital Gains Tax?

You have to pay capital gains taxes when you sell an asset for profit, including stocks, bonds or real estate. If you own the asset for over a year, you must pay long-term capital gains tax. According to the IRS, the tax rate on most net capital gains is no higher than 15% for most individuals. If you hold the asset for less than a year, you'll pay short-term capital gains tax.

Short-term capital gains are taxed according to your standard tax rate. Long-term capital gains are subject to 0%, 15% or 20%, based on your taxable income. If your total taxable income is less than or equal to $44,675 for single filers or $89,250 for married couples filing jointly some or all net capital gain may be taxed at 0%.

The potential impact on homeowners who sell their property is huge. Unless you qualify for 0% capital gains tax, you could pay up to 20% on the gains from the home. If the capital gains — the difference between what you paid and what you earned on the sale of the property — is $200,000, that could mean up to $40,000 in capital gains tax.

Understanding Capital Gains Tax on Real Estate Investing

From a 121 home sale exclusion to a 1031-like-kind exchange to defer taxes, there are options to defer or defray capital gains taxes for real estate investing. Here's what you need to know.

Primary Residence Exemption

A 121 home sale exclusion or a primary residence exclusion allows you to exclude a portion of the capital gains from the sale of your primary residence. To use a 121 exclusion, you'll exclude a portion of the capital gains from your taxable income to reduce the tax burden of selling a home.

To be eligible, the home must be your primary residence, and you must have lived in it for at least two of the five years preceding the sale. You may exclude up to $250,000 of capital gains or $500,000 for married couples filing jointly. You can only use a 121 home sale exclusion once every two years. The types of homes that can qualify for a primary residence exclusion include:

• Condominiums
• Single-family homes
• Cooperative apartments
• Mobile homes
• Trailers
• Houseboats

1031 Exchange: Tax-Deferred Investment Strategy

A 1031 exchange is popular among real estate investors. A 1031 exchange allows for tax deferral on capital gains. A 1031, or like-kind exchange, allows you to defer capital gains taxes on the sale of an investment property by reinvesting the proceeds into a similar property. In that way, you can carry forward your investments indefinitely without immediate tax consequences.

Suppose you bought a rental property for $150,000 and made $20,000 in upgrades. If you sell the property for $300,000 five years later, you'll have capital gains worth $130,000. You'll need to pay capital gains taxes that could be between 15% and 20%, or $19,500 to $26,000. If, instead of taking the capital gains, you decide to buy a duplex with two homes for $350,000, you can use a 1031 exchange.

To do a 1031 exchange, you must purchase a similar property within 45 days of the sale. You'll need a Qualified Intermediary (QI) to hold your funds in escrow until you purchase another property to ensure compliance with the exchange rules.

After the 1031 exchange, when you file taxes, you will submit Form 8824 with the transaction details. In that way, you can defer capital gains taxes as long as you don't buy a property that is drastically different in quality or do not purchase another property at all.

Understanding the Timeframe

To take advantage of the 1031 exchange, you have 45 days from the sale date of one property to purchase another. That's a short timeframe to complete the reinvestment process. For that reason, you'll want to have a new property lined up before you sell the original property.

Suppose you purchase a property like an apartment building and plan to make one of the units your primary residence. In that case, there are additional limitations from the IRS that may cause you to forfeit the tax deferral accidentally.

Potential Tax Consequences

Situations where capital gains tax may still apply despite reinvesting in another house are

• If the new property is drastically different in quality to the original property
• If you decide to make the new property your primary residence

In addition, according to the IRS, taking control of cash or proceeds from the sale before the exchange is complete "may disqualify the entire transaction from like-kind exchange treatment and make all gain immediately taxable." For that reason, using a QI is essential!

Consulting with a Tax Professional

If you plan to use a 1031 exchange to defer capital gains, seek advice from a tax professional or financial adviser. An expert who fully understands your unique tax situation can help you find the optimized solution to save more while complying with all relevant tax laws and filing requirements.

For example, a capital gain is deferred but not forgiven in a like-kind exchange. You have to track the basis correctly to comply with Section 1031 regulations. A qualified tax professional can help you calculate and track your basis in the new property acquired in the exchange. You can also learn more about how investments are taxed.

Using a Qualified Intermediary

The role of a qualified intermediary in a 1031 exchange can't be over-emphasized. Working with a qualified intermediary in handling the complex transactions involved will protect your ability to defer capital gains and ensure compliance with IRS rules. These professionals are used to working with investors and can help walk you through the process and recommend the steps that you need to take.

Reducing or Deferring Tax Liability on Real Estate Investments

A 1031 exchange is the most reliable tool for real estate investors to reduce tax liability on rental properties or other real estate investments. To take advantage of this option, compliance with all IRS guidelines is essential, or you could end up liable for the full capital gains.

Likewise, with a primary residence exemption, you might be exempt from paying capital gains tax on the sale of your primary residence. Speak with a tax professional to understand the implications of your situation and maximize possible savings.

Frequently Asked Questions