Gardner: Tax strategies to save money on sale of real estate (column)
Lorraine asks: I have a house that I am selling. It is in another town where I lived before moving here. I lived in the house for two years and then I rented it out for the last four years. I plan to use the proceeds to pay off the mortgage on my current home. Is it accurate that I don’t have to pay capital gains since I am applying the funds to my current home?
Lorraine, unfortunately capital gains taxes could certainly be applicable, depending on whether you made a profit. There is a rule that an individual can receive up to $250,000 in capitals gains on the sale of a home without paying taxes if he/she lived in the house two of the last five years. A couple can receive up to $500,000 in capital gains without paying taxes if they both lived there two of the last five years. (Additional rules apply if a move for a job is involved.) In your case, Lorraine, you lived there two of the last six years, one year too many, and you do not qualify for the tax break. Your cost basis is the original purchase price, plus closing costs on the purchase, plus improvements to the home, plus closing costs on the sale. Your capital gains are the difference between the sale price and your adjusted cost basis. The good news is that it will be treated as long-term capital gains at a 15 percent or 20 percent federal tax rate unless your income is low enough that you qualify for the zero percent tax bracket. I recommend that you start compiling your cost basis information now so that once the house sells, you can estimate what your tax bite will be based on the 2016 tax tables and then look at it again when the 2017 tax tables are published. By doing this now you can set aside the funds needed during the year instead of scrambling to gather the funds when you file your return next year.
This tax rule is one of the best tax breaks an individual or couple can get and one that almost anyone can benefit from who owns a residential property that goes up in value. Your home is one of your biggest investments and it is important that you not forget this rule and, if possible, plan around it when you sell and make your next purchase. At a minimum, you only must live in your home the last two years. Consult your CPA for all the rules.
John asks: I have been hearing about something called 1031 exchanges. I have a condo that I rent out but I am considering upgrading to a townhouse that is larger and more expensive. My concern is that I will have to pay capital gains tax on the condo when I sell it. Is the 1031 appropriate and how would it work?
That is a great question, John. A 1031 exchange may be appropriate if certain criteria are met. The rules are much more stringent than in the last scenario. A 1031 exchange is a like-kind exchange under the Internal Revenue Code, Section 1031. Basically, this provision allows you to tax defer capital gains from the sale of an investment property when you reinvest the proceeds into a similar property used for the same purpose within a designated period of time. It is important to note that the capital gains are tax-deferred, not tax-free. The like-kind exchange can be property only or it can also include cash. This is the cleanest exchange. Others can include property and/or liabilities and cash that are not part of the exchange and their inclusion may create a taxable event in the exchange year. Also, the exchange should be for a property of the same or greater value or there will be a recognized gain. Individuals and any taxpaying entity that own investment property may qualify for a 1031 exchange if all the rules are followed:
• Property must be used for business or investment purposes and not as a residence or second home;
• Properties must be similar enough to be considered like-kind and of the same nature or character or class;
• Timing of exchange must strictly adhere to the Code. A swap on the same day is ideal, but in lieu of an immediate swap, a replacement property must be identified within 45 days of the sale of first property and the new property must close and the exchange completed no later than 180 days after sale of exchanged property;
• Hire a qualified intermediary to hold cash proceeds until the exchange is complete. You cannot take possession of the funds or the transaction will be disqualified as a 1031 exchange and the gain will become taxable. In addition, you cannot use your broker, accountant or attorney or anyone you have worked with during the last two years.
• Use a title company that knows how to handle 1031 exchanges. Land Title Guarantee Company is a good example, and it has a separate entity, Land Title Exchange Corporation, that does 1031s exclusively.
Like-kind exchanges are complex and before considering, it is important that you first discuss with your CPA and then work through the logistics with your real estate professional and mortgage broker for a seamless event.
Nancy Gardner is a Certified Financial Planner. She and her husband Bill and their dog Daisy split their time between Summit County and Montgomery County, Texas. Send your questions to Nancy at firstname.lastname@example.org.
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