When people start thinking about selling a home, most of the conversation naturally revolves around real estate.
What is the home worth? How much equity do I have? Where am I going next? What will my next home cost?
Those are all important questions, but there's another one that can be just as important:
What are the tax consequences if I sell?
I've helped many clients sell longtime primary residences without owing federal capital gains tax on the sale because their gain fell within the primary residence exclusion. I've also worked with homeowners whose properties appreciated so much that their gains exceeded the exclusion, sometimes substantially.
I've seen this particularly with longtime homeowners who purchased their homes decades ago for a fraction of what they're worth today.
That doesn't necessarily mean selling is a bad idea. It means that before selling a property with significant appreciation, the potential tax consequences should be part of the decision.
The $250,000 and $500,000 Primary Residence Exclusion
One of the biggest tax advantages available to homeowners is the federal capital gains exclusion on the sale of a primary residence.
Generally, qualifying homeowners may be able to exclude up to:
- $250,000 of gain for an individual
- $500,000 of gain for many married couples filing jointly
There are additional requirements and exceptions, but one of the most important is commonly referred to as the 2-out-of-5-year rule.
Generally, during the five-year period ending on the date of the sale, you must have owned the home for at least two years and lived in it as your primary residence for at least two years.
The two years of residence do not necessarily have to be consecutive.
For homeowners who have accumulated substantial equity over many years, this exclusion can represent an enormous tax benefit.
Be Careful When Turning a Former Home Into a Rental
Here's a situation that I think deserves more attention.
Imagine you've lived in a home for 15 or 20 years and accumulated substantial equity. You decide to move, but instead of selling the old house, you keep it as a rental property.
Initially, you may still satisfy the 2-out-of-5-year residence requirement. As more time passes, however, you can eventually fall outside that window.
As a practical matter, someone who moves out after already satisfying the ownership and use requirements can generally remain within that particular 2-out-of-5-year test for roughly three years after moving out. Once you've been out of the property longer than that, you may no longer have two years of primary-residence use remaining within the five-year lookback period.
That means the decision to keep a former residence as a rental could potentially affect access to a $250,000 or $500,000 capital gains exclusion.
It's important to understand that the tax treatment of a former residence that becomes a rental can be more complicated than simply counting years. Depreciation, periods of nonqualified use, previous home sales and other circumstances can affect the final result.
That's why I think the timeline deserves serious attention before deciding how long to keep a former primary residence as a rental.
If you're approaching that three-year mark, this is a conversation I'd strongly recommend having with your CPA before making a decision.
What If Your Gain Is More Than $500,000?
This has become increasingly relevant for people who have owned California real estate for a long time.
I've had many clients sell their primary residences and owe no federal capital gains tax because their qualifying gain fell within the applicable exclusion.
I've also represented clients whose homes appreciated well beyond the $500,000 exclusion.
This can be particularly significant for longtime Bay Area homeowners. Someone who purchased a home decades ago may be sitting on hundreds of thousands, or even millions, of dollars in appreciation.
In those situations, the potential tax liability can be substantial.
That doesn't necessarily mean you shouldn't sell.
It simply means the potential tax bill needs to be part of the decision.
When I'm helping someone evaluate a move, I want them to have a realistic picture of what they'll actually have available afterward. That means considering the expected sale price, selling expenses, mortgage payoff and, when applicable, potential taxes.
Only then can you accurately evaluate what your equity will allow you to do next.
If that next move includes buying locally, you can also explore current homes for sale in Rocklin, Lincoln, Granite Bay, Loomis and Auburn.
Investment Properties Have Another Powerful Option: The 1031 Exchange
Primary residences aren't the only properties where tax planning can have a major impact on a real estate decision.
For investment properties, one of the most useful tools available is a Section 1031 like-kind exchange.
A properly structured 1031 exchange can allow an investor to defer recognizing some or potentially all of the gain from the sale of qualifying investment or business real estate when exchanging into qualifying replacement real property.
The important word is defer. A 1031 exchange generally postpones recognition of the gain rather than permanently eliminating the tax.
Another thing investors sometimes misunderstand is the term "like-kind." You don't necessarily have to sell a rental house and purchase another rental house.
Qualifying real estate can potentially include:
- Rental homes
- Multi-unit investment properties
- Commercial real estate
- Land
- Other qualifying real property held for investment or business use
For example, an investor may potentially sell an investment property in California and exchange into qualifying investment real estate in another state. Improved and unimproved real estate can also potentially qualify as like-kind real property.
What About Delaware Statutory Trusts?
Certain properly structured interests in a Delaware Statutory Trust, commonly called a DST, can also qualify as replacement property for a 1031 exchange.
A DST can allow an investor to acquire a fractional beneficial interest in institutional-style real estate rather than directly purchasing and managing an entire replacement property.
DSTs come with their own risks, fees, investment considerations and eligibility requirements, so this is an area where investors should work with qualified tax, legal and investment professionals rather than viewing a DST simply as a way to complete an exchange.
Why Would Someone 1031 Exchange Into Another State?
I'm currently helping clients with exactly this type of situation.
They own investment real estate in our area that has appreciated considerably, but the property's current value relative to the rent it generates doesn't necessarily provide the cash flow they're looking for.
Rather than simply selling, recognizing the gain and paying the associated taxes, we're working through a 1031 exchange strategy so they can sell here and purchase qualifying investment property out of state where the numbers may provide more favorable cash flow.
That doesn't mean an out-of-state property is automatically a better investment. Appreciation potential, management, vacancy, local economic conditions, insurance, property taxes and many other factors still need to be considered.
But a 1031 exchange gives investors another option when deciding whether it still makes sense to hold a highly appreciated California investment property.
For investors considering their options locally, you can also browse current multi-unit and investment properties for sale, including duplexes, triplexes, fourplexes and larger income-producing properties.
The Timing on a 1031 Exchange Is Critical
A 1031 exchange isn't something you want to decide to do after the sale has already closed.
There are strict rules and deadlines.
In a typical deferred exchange:
- The replacement property generally must be identified within 45 days after the relinquished property is transferred.
- The replacement property generally must be received within 180 days after the transfer, or by the applicable tax-return due date, including extensions, if earlier.
The exchange also needs to be structured properly. Deferred exchanges commonly use a qualified intermediary so the seller does not receive or control the proceeds in a way that would jeopardize the exchange.
This is why planning before the sale is so important.
Sometimes the Most Important Call Isn't to Your Realtor
As a real estate broker, I can help you determine what your property is worth, estimate selling expenses, evaluate your real estate options and put together a strategy for your next move.
But I'm not a CPA, and I don't give tax advice.
When someone owns a property that has appreciated substantially, I frequently recommend that they speak with their CPA before we make a final decision about selling.
Sometimes that conversation confirms that the tax consequences are minimal.
Other times it changes the entire strategy.
I've seen enough real estate transactions over the years to know that what appears to be a simple decision about whether to sell can look very different once taxes, replacement property, cash flow and long-term financial goals are considered together.
Final Thoughts
Real estate is often one of the largest assets people own, and after years or decades of appreciation, the tax consequences of selling can become significant.
If you're considering selling:
- A longtime primary residence
- A former residence you've converted to a rental
- A highly appreciated investment property
- An investment property you're considering exchanging into another property
it's worth understanding the potential tax implications before you put the property on the market.
The primary residence exclusion and 1031 exchange rules can be incredibly valuable, but they also come with requirements, exceptions and deadlines. A mistake in timing or planning could potentially cost a substantial amount of money.
If you're considering a move, I'm always happy to help you evaluate the real estate side of the equation, determine what your property may be worth and discuss the options available for your next move.
And when significant tax consequences are involved, a conversation with your CPA before you sell is usually time well spent.
Contact me to discuss your real estate options.
Patrick Hake
Broker Associate
eXp Realty of California
License #01349088
Call or text: (916) 316-5626
www.OwnPlacer.com/patrick-hake.php
This article provides general information only and is not intended as tax, legal or investment advice. Tax rules are complex and individual circumstances vary. Consult your CPA, tax attorney or other qualified professional before making decisions based on potential tax consequences.
Posted by Patrick Hake onEnjoy this blog post? Click here to subscribe for updates
Leave A Comment