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If you sell your home this year, did you know there is a way to avoid paying taxes on more than $500,000 in profit. This especially applies to you if you have lived in a Windermere home for quite some time with a substantial gain in value.
You may be familiar with Internal Revenue Code Section 121, which allows married couples to exclude up to $500,000 of profit from their primary residence sale ($250,000 for single taxpayers). This exclusion, however, may not fully cover profits in high-value markets, leaving the remainder subject to federal and state capital gains taxes, along with net investment income tax.
One lesser-known method to maximize tax benefits is converting your home into a rental property. By doing this, you can take advantage of both the Section 121 exclusion and the Section 1031 exchange to exclude some gains and defer taxes on the rest. Typically, tax advisors suggest renting out the property for a minimum of two years to establish its eligibility as a rental. However, renting for too long could disqualify you from the Section 121 exclusion, which requires that the home be your primary residence for at least two of the past five years.
Consider This Scenario
John and Jill Brown, who have owned their home for 40 years, originally bought it for $100,000. The home is now valued at $1 million, yielding a $900,000 gain. If they sell without converting it to a rental, they can exclude $500,000 of the gain but must pay capital gains tax on the remaining $400,000.
Instead, they opt to convert their home into a rental. After renting it for two years, they sell the property for $1 million. Since they lived in the home as their primary residence for at least two of the past five years, they can exclude $500,000 of the gain. They then utilize a 1031 exchange to acquire a replacement investment property, deferring taxes on the remaining gain.
Once a fully seasoned income producing property you’re able to defer the remaining gain, the requirements are to purchase a replacement property with a market value equal to or greater than the relinquished property; and invest all equity from the relinquished property into the new one.
However, when gain is excluded under Section 121, the required value and equity investment in the replacement property is reduced by the excluded gain amount.
Combining the sale of a primary residence with a 1031 exchange requires adherence to all Section 121 and Section 1031 rules. Revenue Procedure 2005-14 outlines how these regulations can be combined, including situations involving a personal residence with a home office.
Essential Points to Consider
- To qualify for the $500,000 exclusion ($250,000 for single taxpayers), you must own and live in your home as your primary residence for at least two of the past five years.
- The Section 121 exclusion is available only once every two years.
- Gain attributable to depreciation deductions taken since May 6, 1997, cannot be excluded under Section 121 but can be deferred under Section 1031.
- For Section 1031 deferral, both the sold property and the acquired property must be used in a business or held for investment at the time of the exchange.
Expertise in Rentals
After consulting your tax professional, taking this step may be the best option for avoiding taxes on your home. And when you’re ready, call the Windermere Lakefront Team at The Real Estate Collection for property management of your rental home and expertise in buying and selling beautiful Windermere Lakefront and surrounding properties.
The Real Estate Collection, Windermere Lakefront | windermerelakefront.com
