When it comes to the tax code, there are several tax efficient solutions for real estate sales. Whether or not any of the solutions make sense for you will likely depend on a number of factors including whether the property is a primary residence or other type of real estate, the amount of the capital gain and depreciation recapture you may be subject to, and your plans with the proceeds of the sale.
In this post, we will review five strategies that you can consider depending on your particular set of circumstances. Depending on your goals and potential needs for the funds, there is always the option of selling and simply paying the taxes owed. While there is a cost associated with this solution, it does provide the most flexibility as you can use the proceeds of the sale however you’d like to.
Primary Residence Capital Gain Exclusion
If you are selling your home, you can potentially qualify for an exclusion of $250,000 in gains if single and $500,000 if married filing jointly. In order to qualify, you must meet the “ownership and use test.” This test requires that you both lived in and owned the residence for two out of the last five years.
A notable item relating to this test is that it does not have to be the most recent two years. Occasionally, families move out of an old house, try to rent the house, and then later decide that they no longer want to be a landlord. As long as they did not move out more than three years prior they could still qualify for the exclusion as long as they had lived in the home for two years before moving.
Example: Jim and Jane lived in their home from 2015-2020 before buying a new home. They decide to try renting their property after moving out but after a year with a problem tenant decide that they no longer want to deal with the headache and will sell the house. Because they still lived in the home for two out of the past five years, they can exclude up to $500,000 in gains on the home.
If you don’t meet the requirements of this test, you can still potentially receive an adjusted exclusion in a few circumstances:
- You sold due to a change in jobs and your work location is at least 50 miles further from your home than your old job
- Your doctor recommended you move due to health conditions
- You’re selling due to death, divorce, or some other unforeseen circumstance
In this case, you would take the number of months you did live in the residence divided by 24 and that would determine the percentage of the exclusion you qualify for. For example, a married couple that lived in their home for 18 months would qualify for 75% (18/24) of the $500,000 exclusion amount or $375,000. If the gain on the home is less than $375,000 there will be no tax due upon sale.
While this exclusion applies to capital gains, it does not apply to depreciation recapture. In a primary residence, this would most often be encountered by individuals that take a home office depreciation deduction. This will still be subject to depreciation recapture which is currently taxed as ordinary income up to a maximum rate of 25%.
Section 1031 Exchange
Also known as a like-kind exchange, the 1031 exchange allows you to potentially defer capital gains by using the proceeds of a sale toward a like-kind property. To fully defer the capital gain, the new property must be equal to or greater in value to the property sold. This type of exchange is not allowable for personal residence sales, the real estate must be an investment property and must meet the following requirements:
- The replacement property must be like-kind and of the same nature, character or class
- Real property must be exchanged for real property
- Real estate within the United States can’t be exchanged for real estate outside of the United States
When completing a 1031 exchange, there are two time limits that must be adhered to. Property owners must use a qualified intermediary specializing in these exchanges to ensure the deadlines are met and to hold the funds during the time period between sale and purchase to avoid constructive receipt.
The first time limit is known as the identification rule and it states that you have 45 days from the date you sell your property to identify the property you will be purchasing. The identification must be signed by you and clearly identify the replacement property including address.
The second time limit is known as the 180-day rule and it states that the exchange must be completed within 180 days of the sale of the exchanged property or the due date of the income tax return for the year the property was sold, whichever is earlier. The property purchased must also be substantially the same as the property identified during the identification period.
Assuming the rules of the 1031 are met you are able to roll the capital gain from the relinquishing property over to the replacement property. The basis on the new property will be adjusted to reflect the gain from the relinquished property.
Section 1033 Exchange
A 1033 Exchange, sometimes referred to as an eminent domain exchange, applies to properties that have undergone involuntary conversions. This can include not only forced sales by government imminent domain but also the threat of condemnation or unforeseen natural disasters like a fire, earthquake, flood, hurricane, or other destruction.
The tax implications of a 1033 exchange are similar to a 1031 exchange but the requirements tend to be much more lenient. The replacement property must still be like-kind but there is no identification rule and the new property purchase can take 2-3 years from the date of the forced sale.
Additionally, you are not required to hire a qualified intermediary in this type of exchange and can take constructive receipt of the proceeds until the new property is purchased. During this time there are no requirements on what you can do with the funds but you will be required to use the proceeds of the full conversion amount upon purchase of the new property.
That said, in a 1033 exchange you are not required to maintain the same debt leverage ratio, you must only match the property value of the converted property. This means an individual with a $1 million property that is paid off could acquire a new property worth $1 million but take out a loan on 50% of the value leaving them with $500,000 cash on hand that is not subject to capital gains taxes.
Section 721 UPREIT Exchange
A Section 721 “UPREIT” exchange is similar to a 1031 exchange but with added diversification benefits. In this type of transaction, you sell your property to a Real Estate Investment Trust (REIT) in exchange for a corresponding number of operating partnership units in the acquiring REIT. This allows you to manage your capital gains tax liability as you can sell shares when appropriate as opposed to selling the entire property and realizing all of the gains at the same time.
Typically, the biggest obstacle a property owner will face with this type of transaction is finding a REIT that wants to purchase your property. Additionally, once you have completed an UPREIT transaction you can’t undo the exchange or complete any other types of tax-deferred exchanges in the future.
Qualified Opportunity Zone
Introduced as part of the Tax Cuts and Jobs Act, qualified opportunity zones are low-income communities and neighboring areas defined by the U.S. Department of Treasury. While it is common for Opportunity Zone investments to be real estate based, the investment can be in any qualifying business that operates withing a defined opportunity zone.
There are three primary tax benefits to investors that invest realized capital gains in an opportunity zone business or fund:
- Deferral: Capital gains that are re-invested into an opportunity zone within 6 months of realization can be deferred until as late as December 31, 2026.
- Reduction: If an opportunity zone investment is held for at least five years the tax bill on the capital gains is reduced by 10% and if held for at least seven years the reduction is increased to 15%.
- Elimination: If an opportunity zone investment is held for at least ten years the federal capital gains on the opportunity zone investment is eliminated.
Each of the solutions described above comes with pro’s and con’s that may impact your situation. After analyzing the options you may come to realize that none are applicable or that the restrictions are not worth the benefits provided. As always, it is a good idea to review any strategies with your financial planner and tax advisor before proceeding.
If you’d like to discuss any of these strategies and how they might apply to your situation, schedule a meeting with our team here.
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Disclosures: Any opinions are those of Michael Dunham and not necessarily those of Raymond James. The information contained in this blog does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Hypothetical examples are included for informational purposes only.
Please note, changes in tax laws may occur at any time and could have a substantial impact upon each person’s situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.