How can we minimize capital gains taxes when selling rental property?
If my wife and I sold a rental property for $150,000 and purchased a new property for $300,000, how would we avoid capital gains taxes? I am aware of the 1031 exchange option, but we want the new property to be our primary residence. Could we rent it for a period of time before living in it? How long?
Other responses have clearly addressed the details of doing a 1031 exchange, but another option you might want to consider is rolling the capital gains on your rental property into an Opportunity Zone investment and the principal portion of the sale into the new primary residence.
The Tax Cuts and Jobs Act of December 2017 created the Opportunity Zone program, and people reinvesting their capital gains into a qualified opportunity zone fund (QOF) can potentially get significant tax benefits. You’d have to invest the capital gain of your rental property within 180 of the sale though, and the investment would have to be in one of the 8700 eligible opportunity zones nationwide.
If you roll the capital gain into a opportunity zone investment, you can take advantage of three potential tax benefits: 1) deferral of the capital gain until 2026; 2) a reduction of the capital gain by 10% or 15% if you hold onto the new investment for 5 or 7 years, respectively; and 3) elimination of future capital gains on the investment if you hold on to it for 10 years.
Unlike a 1031 exchange, you don’t have to invest the basis portion of your rental sale to get the tax benefits, so you can free up the non capital gain portion of the sale for your new home purchase. However, you do have to have cash available when the capital gains taxes are due in 2026.
New regulations from the IRS on QOF investments are being released regularly, so please consult a tax professional if you’re considering this option.
To qualify for a 1031 exchange, the sale transaction must be structured ahead of time as a 1031 exchange, usually through a qualified 1031 exchange intermediary. If you already sold the rental property and closed on it, a 1031 exchange is no longer possible.
The other key rules of a 1031 are:
1) You must identify a replacement property within 45 days of selling the initial property.
2) You must purchase (and close on) a replacement property within 180 days of selling the initial property.
If you haven't closed on the rental property you sold, you can structure a 1031 purchase for a replacement property that (after 1-2 years as a rental property) could possibly become your primary residence. Please check the details with your CPA.
Let's say you did the above (sold the rental property as a 1031 exchange and then used the proceeds to buy a rental house, which later becomes your primary residence). When you convert your rental property to your primary residence, you would owe capital gains tax at the point of conversion. So, the net result is that you would only delay the capital gains by 1-2 years, which does not seem worth the trouble.
One other way to reduce the capital gains is to sell something in your investment portfolio that is at a loss position.
If you want to reduce or eliminate capital gain taxes on the sale of rental property, then before you sell your property you need to set up the right kind of Qualified Intetermediary to receive your funds at closing. Doing so will allow you to take advantage of several 1031 like options that exist in the tax code reduce or eliminate taxes.
It is critical that you set this up before hand to take advantage of this planning opportunity.
If you have already sold your property, you are limited to your tax reduction strategies but there are several proactive steps that you still may be able to take.
If you have already sold your rental property and purchased a new property then a 1031 exchange is no longer available. The 1031 exchange has specific guidelines to be followed. Once you sell your rental/investment property there must be an exchange of properties. The simplest type of Section 1031 exchange is a simultaneous swap of one property for another.
To qualify as a Section 1031 exchange, a deferred exchange must be distinguished from the case of a taxpayer simply selling one property and using the proceeds to purchase another property (which is a taxable transaction). Rather, in a deferred exchange, the disposition of the relinquished property and acquisition of the replacement property must be mutually dependent parts of an integrated transaction constituting an exchange of property. Taxpayers engaging in deferred exchanges generally use exchange facilitators under exchange agreements pursuant to rules provided in the Income Tax Regulations.
Both the relinquished property you sell and the replacement property you buy must meet certain requirements.
Both properties must be held for use in business or for investment. Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment. So this would also disqualify your 1031 exchange as well, although if you do want to use the property you swapped for as your new second or even primary home, you can not move in right away. In 2008 the IRS set forth a safe harbor rule under which it said it would not challenge whether a replacement dwelling qualified as investment property for purposes of a 1031. To meet that safe harbor, in each of the two 12-month periods immediately after the exchange: (1) you must rent the dwelling unit to another person for a fair rental for 14 days or more; and (2) your own personal use of the dwelling unit cannot exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
Both properties must be similar enough to qualify as "like-kind." Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate.
The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties. The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary.
Replacement properties must be clearly described in the written identification. In the case of real estate, this means a legal description, street address or distinguishable name. Follow the IRS guidelines for the maximum number and value of properties that can be identified.
The second limit is that the replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property or the due date of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier. The replacement property received must be substantially the same as property identified within the 45-day limit described above.
It is important to know that taking control of cash or other proceeds before the exchange is complete may disqualify the entire transaction from like-kind exchange treatment and make all gain immediately taxable.
If cash or other proceeds that are not like-kind property are received at the conclusion of the exchange, the transaction will still qualify as a like-kind exchange. Gain may be taxable, but only to the extent of the proceeds that are not like-kind property.
One way to avoid premature receipt of cash or other proceeds is to use a qualified intermediary or other exchange facilitator to hold those proceeds until the exchange is complete.
It is critical that you and your tax representative adjust and track basis correctly to comply with Section 1031 regulations.
Gain is deferred, but not forgiven, in a like-kind exchange. You must calculate and keep track of your basis in the new property you acquired in the exchange.
The only way to avoid capital gains treatment on a real estate rental / investment property sale is by doing a 1031 exchange. The exchange avoids immediate taxation but technically just “defers” it down the road.
Exchanging a rental into your primary residence is a prohibited transaction. You can’t 1031 exchange into any personal or related personal use assets.
Some people exchange one rental for another and then convert that rental down the road into personal use and that is ok. There is no true bright line test or rule to this. At minimum, you should have at least two years’ worth of tax returns showing the replacement property was placed into service as a rental in my opinion.
Also realize that “intent” is an important element. According to Jack Hackett at Farr Law, he says, “The replacement property must be owned for at least 24 months immediately after the exchange (the qualifying period) and in each of the two 12-month periods in the qualifying period: (1) the taxpayer must rent the replacement property to another person at a fair rental for 14 days or more; and (2) the taxpayer’s personal use of the replacement property must not exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at fair rental. It can be rented to a family member as a principal residence so long as market rent is paid.”
The longer you rent it, the safer the conversion to personal use. The shorter the period, the more it can be questioned and if you lose, you owe all the taxes on the transaction. Make sure your CPA signs off on this transaction and your actions.