When you sell your home, you make a capital gain – profits earned because the value of the property has increased over the holding period. And that makes you liable to pay capital gains tax. But, can you avoid capital gains tax by buying another house?

Fortunately, the Internal Revenue Service (IRS) allows some capital gains break. The first one is Section 121 aka home sale exclusion. This allows taxpayers to exclude capital gains from the sale of their primary residence. The other option for a tax break is Section 1031 aka like-kind exchange. This option is only for property investors. It allows taxpayers to defer payment of capital gains tax by using the proceeds from the sale of one investment property to buy another similar real estate.

Now the big question is, do you qualify for any of these, and can you avoid capital gains tax by buying another house? Let’s find out. 

What is capital gains tax?

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Capital gains refer to any monetary profit earned from selling an asset whose value has increased over the holding period. These assets could be tangible property such as personal property or real estate, or intangible property such as intellectual property or equity shares. 

An investment held for more than a year qualifies for long-term capital gains, while one that’s held for less than a year will get you short-term capital gains. The former is taxed at a lower rate of around 15%, 20%, or 28% depending on the income tax bracket and the asset type, while the latter is taxed as ordinary income and can be as high as 37%. In both situations, the taxable event must be reported to the IRS.  

How is capital gains tax calculated in real estate?

Capital gains tax rate depends on several factors such as income tax bracket, marital status, the duration of home ownership, and if the property is a primary residence, a second home, or an investment property.

Therefore, calculating the tax rate is complex. Keep in mind it’s only assessed on the profit. 

For example, if you bought a house for $150,000 and sold it five years later for $225,000, your net profit would be $75,000. This is assuming you’ve not claimed any tax deduction pertaining to qualifying home improvements or sale closing costs. You only pay taxes on the net profit amount. While the residential real estate rates are typically lower than income tax rates, the capital gains tax can add up significantly. 

If your taxable income is $41,676 to $459,750 as a single filer, and $83,351 to $517,200 for married filing jointly, you can expect to pay 15% of the profit.

Today, however, the IRS offers home sellers several ways to avoid or reduce their capital gains taxes. Selling a primary residence could help you save up to $250,000 or $500,000, depending on your filing status.

What are the capital gains tax exemptions for primary residences?

Tax deductions

Your home is your capital asset. In normal circumstances, it will appreciate in value – making you liable for capital gains tax. However, there are some exemptions brought about by the Taxpayer Relief Act of 1997.  

According to the act, if you fulfill the following conditions, you may qualify for a capital gains tax exemption at the time of the sale of your home. If you have:

  • Owned the primary residence for a minimum of two years. 
  • Lived there for two years or more. 
  • Haven’t claimed any capital gains exemption from the sale of a primary property within the last two years. 

If you meet the above requirements, you can qualify for a capital gains tax exemption. The exemption amount is $250,000 for single-filing taxpayers and $500,000 if married. 

If a married couple purchased a primary house and lived in it for 10 years before deciding to sell for a profit of $75,000, they would not be liable for any capital gains tax. Not only do they meet all the qualifying requirements but also the gain is less than $500,000. Without a capital gains tax to worry about, they’ll be free to use that income however they please. 

How to calculate capital gains tax on rental property?

You can expect to pay between 15 and 20 percent in long-term capital gains taxes – more if you’ve previously claimed a depreciation deduction for the same property. Short-term capital gains taxes are higher.  

Therefore, if you’re planning to sell a rental property you’ve owned for less than a year, it’s best to stretch the ownership to a year.

Can you avoid capital gains tax by buying another house for investment purposes?

How long is option period

When selling one investment property and buying another, owners may be able to defer their capital gains taxes. The 1031 exchange or the like-kind exchange allows this to happen. A taxpayer may defer a tax on an investment property sale by buying a similar property. Basically, if you’ve sold an investment property and are using the proceeds of the sale price into buying another investment property, you can avoid capital gains taxes. You can put the proceeds from the sale into an escrow account and use the funds within the next 180 days to find and purchase another real estate. 

What are the requirements of a like-kind exchange?

You may utilize this type of tax break only if you meet three general requirements:

  • Your property must be an investment asset, not a home for personal use as a primary residence, secondary residence, or vacation home.
  • The investment property must generate rental income or any other income for you. 
  • The new property you buy must be similar to the house you sold – it should be of the same “character and class”. 

Are there any ways to reduce the capital gains tax?

You may mitigate your capital gains tax by taking any of the following steps. 

  • Converting the rental property to a private residence by moving into the property for at least two years.
  • Taking advantage of the opportunity zone created by the 2017 Tax Cuts and Jobs Act. If you choose to invest in areas identified as economically disadvantaged or low-income communities, you’ll get a step up in tax basis after the first five years. And any capital gains after 10 years will be tax-free.
  • Lowering taxable profit or gains by claiming qualifying deductions for repairs, improvements, and upgrades such as a bedroom addition or a kitchen renovation. Or, by citing losses in investment property income due to tenant issues. 

If you choose to take the third route, remember to keep all the records, documents, receipts, bills, and credit card statements to support your expense claims.

Key takeaways

A home seller will always want to make a good profit on a real estate deal. However, if you don’t have a strategy, the capital gains tax can take a huge chunk of the profit made from the sale. And, the amount can be quite substantial if the property has increased in value manifold. 

Fortunately, avoiding or reducing the capital gains tax is possible. If you sell your primary residence, you can exempt a good amount from the tax – $250,000 if you are a single taxpayer and $500,000 if you’re married and filing jointly. Keep in mind that you can use this only once every two years. If it’s an investment property, the Internal Revenue Code Section 1031 allows you to avoid capital gains tax on the sale by buying another house – after meeting certain requirements. And always remember that short-term capital gains tax rates are higher than long-term capital gains tax rates so it pays to keep your property for a longer period of time.

So, can you avoid capital gains tax by buying another house? was last modified: February 22nd, 2023 by Ramona Sinha
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