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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?

Real Estate, Taxes
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April 2019

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.

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