How to Defer Capital Gains Tax on Real Estate

When real estate is sold for more than its original purchase price plus improvements, the profit is generally subject to capital gains tax. Gains are short-term (held one year or less) or long-term (held longer). Short-term gains are taxed at ordinary income rates; long-term gains benefit from lower rates (0-20% based on income/filing status).

Deferring capital gains tax postpones real estate profit tax payments. This delay provides financial advantages, like keeping capital invested for further returns. It also benefits from inflation, as deferred tax liability’s purchasing power may decrease. Deferral is advantageous if anticipating a lower future tax bracket, potentially reducing the overall tax burden when gain is recognized.

Deferring Through Like-Kind Exchanges

A like-kind exchange defers capital gains tax and depreciation recapture when real estate held for productive use or investment is exchanged for other “like-kind” real property. Section 1031 of the Internal Revenue Code allows investors to reinvest full sale proceeds without immediate tax implications. The term “like-kind” is broadly interpreted for real estate; one investment property can be exchanged for another, even if they differ in nature or quality (e.g., raw land for a commercial building).

To qualify for a 1031 exchange, requirements and timelines apply. Properties must be held for productive use in a trade or business or for investment purposes; personal residences do not qualify. After selling the relinquished property, the investor has 45 calendar days to identify potential replacement properties. This identification must be in writing, specifying up to three properties regardless of their fair market value, or any number of properties if their aggregate fair market value does not exceed 200% of the fair market value of the relinquished property.

Following identification, the investor has 180 calendar days to acquire replacement properties. This period runs concurrently with the 45-day identification period. A Qualified Intermediary (QI) is required. The QI holds sale proceeds, preventing direct investor access and immediate taxation.

The investor provides the QI with documentation for both properties, including sales and purchase contracts. The QI handles fund transfers, ensuring compliance with non-receipt rules. Any cash or non-like-kind property (“boot”) received can trigger partial gain recognition and is taxable to the extent of the gain realized, even if the exchange otherwise qualifies.

A 1031 exchange begins before selling the relinquished property, by engaging a Qualified Intermediary. The QI holds sale proceeds. When the relinquished property closes, proceeds transfer directly to the QI, not the seller. The investor identifies replacement properties within 45 days and acquires them through the QI within 180 days.

The deferral of capital gains is reported to the IRS on Form 8824, “Like-Kind Exchanges.” Form 8824 captures information on both properties, including transfer dates, fair market values, and descriptions. It also calculates deferred gain and any taxable boot received.

Deferring Through Qualified Opportunity Funds

Capital gains can be deferred by reinvesting into a Qualified Opportunity Fund (QOF). A QOF is an investment vehicle for eligible property in Qualified Opportunity Zones, economically distressed communities designated by the U.S. Treasury. This strategy defers capital gains from any asset sale, not just real estate, by reinvesting into a QOF within 180 days.

Capital gains must be recognized and reinvested into a QOF within 180 days. Benefits tie to the QOF investment’s holding period. The original deferred gain is recognized on the earlier of QOF investment disposal or December 31, 2026.

Beyond deferral, incentives exist for longer holding periods. Holding the QOF investment for at least five years increases the original deferred gain’s basis by 10%, reducing taxable deferred gain. Seven years of holding increases basis by an additional 5% (total 15%). New capital gains from the QOF can be excluded if held for at least 10 years.

Investing a capital gain into a certified QOF requires identifying a suitable QOF and making the investment. QOFs can be corporations or partnerships and must hold at least 90% of assets in qualified opportunity zone property. Investors should ensure the QOF is certified and compliant. Tracking the holding period is important for realizing tax benefits.

QOF investment reporting involves IRS forms. Investors file Form 8997, “Initial and Annual Statement of Qualified Opportunity Fund (QOF) Investments,” to report QOF investment and deferred gain. Form 8997 provides initial investment information and annual updates to the IRS. QOFs file Form 8996, “Qualified Opportunity Fund (QOF) Annual Statement,” reporting 90% asset test compliance.

Form 8997 requires investor details: deferred capital gain amount, investment date, and QOF’s Employer Identification Number (EIN). Subsequent years’ Form 8997 reports continuing investment and adjustments. Form 8996, filed by the QOF, includes its EIN, total asset value, and percentage invested in qualified opportunity zone property.

Deferring Through Installment Sales

An installment sale involves receiving at least one payment after the tax year of sale. This defers capital gains tax by recognizing a portion of gain with each payment, not upfront. This alleviates immediate tax burden on sellers, especially for large transactions.

Deferral applies to most real estate sales with spread payments. However, certain sales (e.g., inventory for customers) do not qualify. Gain is recognized proportionally to payments. A gross profit percentage determines each payment’s taxable portion.

Gross profit percentage is gross profit divided by contract price. Gross profit is selling price minus adjusted basis and expenses. Contract price is selling price less any existing mortgage assumed by the buyer (if it exceeds seller’s basis). Each payment is multiplied by this percentage to determine annual taxable gain.

An installment sale requires a written agreement outlining payment schedule, interest rates, and terms. The seller retains a security interest until payments are made. Terms must be clearly defined to avoid disputes and comply with regulations.

Installment sales are reported annually on Form 6252, “Installment Sale Income.” It is used for the year of sale and each year payments are received. On Form 6252, the seller provides contract price, gross profit, and total payments received. The form guides taxable gain calculation, applying the gross profit percentage.

This form tracks the installment sale, ensuring correct gain reporting each tax period. It requires information on the property, buyer, and total gross profit. Annual entries reflect payments and the taxable gain portion, allowing compliant deferral.

Deferring Through Primary Residence Sales

Primary residence sales offer a capital gains exclusion under Section 121 of the Internal Revenue Code. This allows homeowners to exclude capital gain from taxable income. This exclusion directly reduces taxable gain, not merely defers it, and can eliminate tax liability on profits up to a threshold.

Qualification requires ownership and use tests. Ownership requires owning the home for at least two years during the five-year period ending on sale date. Use requires living in the home as a primary residence for at least two years during the same five-year period. These two years need not be continuous but must total 24 months within the five-year window.

Exclusion limits are up to $250,000 for single filers and $500,000 for married couples filing jointly. A single individual selling their primary residence with a $200,000 capital gain can exclude the entire amount if ownership and use tests are met. Partial exclusions may apply if tests are not fully met due to unforeseen circumstances (e.g., job change, health issues, divorce).

Most primary residence sales fully covered by the Section 121 exclusion require no specific IRS reporting. If Form 1099-S, “Proceeds From Real Estate Transactions,” is received, it indicates the sale price exceeded the exclusion or other conditions. In these cases, or if gain exceeds the exclusion, the sale must be reported.

If gain exceeds the exclusion limit, or if depreciation was taken (e.g., for a home office), the gain must be reported on Schedule D (Form 1040), “Capital Gains and Losses.” The taxable portion of gain after exclusion is calculated on this form. Form 8949, “Sales and Other Dispositions of Capital Assets,” reports sale details (adjusted basis, sale price). These forms ensure only non-excludable gain is taxed.