How to Defer Capital Gains on a Home Sale
Explore the tax strategies available when you sell your home. Learn the critical rules that determine if your profit is taxed now, later, or not at all.
When you sell your personal residence for a profit, the gain is subject to capital gains tax. The tax code offers ways to reduce or postpone this tax. The most common benefit is the home sale exclusion, which can forgive the tax on the gain entirely, not just postpone it. True deferral options that postpone the tax to a future year are less common for a primary residence but exist in specific situations.
The Home Sale Exclusion
The home sale exclusion, found in Internal Revenue Code Section 121, is the primary tax benefit for selling a main home. A single individual can exclude up to $250,000 of gain from their taxable income, and a married couple filing jointly can exclude up to $500,000.
To be eligible, a homeowner must satisfy two tests. The ownership test requires you to have owned the home for at least two of the five years leading up to the sale. The use test requires you to have lived in the home as your principal residence for at least two of the five years before selling. These two-year periods for ownership and use do not have to be continuous or simultaneous.
Calculating the gain on your home sale involves a basic formula: the home’s selling price, minus selling expenses, minus the property’s adjusted basis. Selling expenses can include real estate commissions, advertising fees, and certain legal fees. The adjusted basis is the original purchase price of the home, plus the cost of any capital improvements.
Capital improvements are distinct from simple repairs because they add value to the home, prolong its life, or adapt it to new uses. Examples include a new roof, a room addition, or a kitchen remodel. Simple maintenance like painting a room or fixing a leaky faucet is a repair and does not increase your adjusted basis.
Homeowners who sell before meeting the two-year requirements may qualify for a partial exclusion. A prorated exclusion is allowed if the sale is due to a change in employment, health issues, or other unforeseen circumstances like divorce or a natural disaster. The amount of the partial exclusion is based on the portion of the two-year period the homeowner met.
Deferral Through an Installment Sale
An installment sale offers a true tax deferral, applying when a seller receives at least one payment for their property in a tax year after the sale. This often happens in seller-financed deals where the buyer pays the seller over time. This method allows the seller to report the capital gain as payments are received, spreading the tax liability over several years.
This method requires calculating a gross profit percentage by dividing the total gross profit by the contract price. Each year, you multiply the principal portion of payments received by this percentage to determine the reportable gain for that year’s tax return. Any interest received on the note is reported separately as ordinary income.
The home sale exclusion is applied first, reducing the total gain. Only the remaining taxable gain is eligible to be reported using the installment method, making it useful for those with gains that exceed their exclusion amount. For example, a single seller with a $350,000 gain would first exclude $250,000. The remaining $100,000 of taxable gain could then be reported on an installment basis as payments are received over multiple years.
The Role of a 1031 Exchange
Homeowners often ask if they can use a 1031 exchange to defer capital gains on a personal residence, but this is not permitted. A 1031 “like-kind” exchange is a tax-deferral strategy available exclusively for investment and business properties. Under Internal Revenue Code Section 1031, the property being sold and the one being acquired must be held for business or investment purposes, which excludes a primary home.
The purpose of a 1031 exchange is to allow investors to roll the proceeds from one investment property into a new one without immediately recognizing a gain. The tax is deferred until the replacement property is eventually sold. This tool is for real estate investors, not personal home sales.
A partial 1031 exchange might be possible for a mixed-use property, such as a duplex where you live in one unit and rent out the other. The gain on the rental portion could be deferred with a 1031 exchange, while the personal unit would still be eligible for the home sale exclusion. This strategy does not apply to a property used solely as a personal residence.
Reporting the Home Sale on Your Tax Return
If your entire gain is covered by the home sale exclusion, you do not need to report the sale to the IRS. The exception is if you receive Form 1099-S, Proceeds From Real Estate Transactions. If you receive this form, you must report the sale on your tax return even if no tax is due.
When reporting is necessary, the sale is detailed on Form 8949, Sales and Other Dispositions of Capital Assets. On this form, you will list the property’s acquisition date, sale date, sales price, and cost basis. To claim your exclusion, you enter an adjustment code on Form 8949 to subtract the excludable amount from your gain.
The totals from Form 8949 are then carried over to Schedule D, Capital Gains and Losses. If you are using the installment sale method to defer gain, you must also file Form 6252, Installment Sale Income. This form is filed for the year of the sale and for each subsequent year you receive a payment.