How to Reduce Capital Gains Tax on Property

When you sell a property for more than you paid, the resulting profit is subject to capital gains tax. This tax applies to the gain from the property’s appreciation, not the total sale price. The amount of tax owed depends on several factors, including how long you owned the property, your income level, and how you calculate the profit. This calculation involves more than just subtracting the purchase price from the selling price; it requires accounting for various costs and adjustments over your ownership period.

Calculating Your Capital Gain on Property

To determine your taxable profit, the formula is the property’s selling price minus its adjusted basis. The selling price is the gross amount the buyer paid, but you can subtract certain selling expenses, such as:

• Real estate broker commissions
• Title insurance
• Legal fees
• Advertising costs
• Transfer taxes paid by the seller

The adjusted basis starts with the original purchase price and is then modified by certain costs and events during your ownership. A higher basis results in a lower taxable gain.

Your property’s basis increases with the cost of capital improvements. A capital improvement is an expense that adds to the value of your home, prolongs its useful life, or adapts it to new uses. Examples include adding a new room, installing a new HVAC system, or replacing the entire roof. These are distinct from simple repairs, such as fixing a leaky faucet or painting a room, which are considered maintenance and do not adjust your basis.

Other costs that increase your basis include settlement fees and closing costs from your purchase, such as abstract fees or charges for installing utilities. Conversely, your basis is decreased by any claimed depreciation from using the home for business or rental purposes. Insurance payments for casualty losses or deductible losses not covered by insurance also lower your adjusted basis.

Utilizing the Primary Residence Exclusion

The primary residence exclusion, or Section 121 exclusion, allows sellers to exclude a large portion of their capital gain from tax. A single filer can exclude up to $250,000 of gain, while married couples filing jointly can exclude up to $500,000. This gain is permanently excluded from your taxable income and is not a tax deferral.

To qualify, you must meet both an ownership and a use test. The ownership test requires you to have owned the home for at least two of the five years before the sale date. The use test requires you to have lived in the property as your main home for at least two of the five years before the sale. The two-year periods for these tests do not need to be continuous.

If you sell your home due to a change in employment, health reasons, or certain unforeseen circumstances, you may be eligible for a partial exclusion even if you don’t meet the full two-year requirements. The IRS considers events like a divorce or having multiple births from one pregnancy as unforeseen circumstances. The amount of the partial exclusion is prorated based on the portion of the two-year period you did meet the requirements.

You can claim the exclusion only once every two years. If you sold another home and used the exclusion within the two-year period before the current sale, you are not eligible to use it again. This provision prevents homeowners from repeatedly buying and selling homes to generate tax-free income in short succession.

Deferring Gains with a 1031 Exchange

A 1031 exchange, or like-kind exchange, allows an individual to defer capital gains taxes on the sale of investment or business property. This is achieved by postponing the tax on the gain as long as the proceeds are reinvested into a similar property. This strategy is exclusively for investment or business real estate and cannot be used for a primary residence.

The term “like-kind” is broadly defined for real estate, allowing for the exchange of different types of investment properties, such as an apartment building for raw land. Both the property sold and the property acquired must be held for productive use in a trade, business, or for investment.

Successfully completing a 1031 exchange requires adherence to strict timelines. From the date you close the sale of your original property, you have 45 days to identify potential replacement properties in writing. You must then close on the purchase of one of the identified properties within 180 days of the sale or by the due date of your tax return for that year, whichever comes first. To ensure you have the full 180-day period, you may need to file for a tax return extension.

A 1031 exchange requires the use of a Qualified Intermediary (QI). You cannot have direct receipt of the sale proceeds, so the QI, an independent third party, holds the funds from the sale. The QI then uses those funds to acquire the replacement property on your behalf to maintain compliance with IRS rules.

Additional Tax Reduction Strategies

The length of time you own a property affects the tax rate on your gain. Property held for more than one year results in a long-term gain, taxed at 0%, 15%, or 20%, depending on your income. Any portion of the gain attributable to depreciation deductions is taxed at 25%. Gains on property held for one year or less are short-term and taxed at higher ordinary income tax rates.

An installment sale allows you to spread out your tax liability by receiving payments from the buyer over multiple years. You report a portion of the gain each year as you receive payments, which can prevent a large, single-year gain from pushing you into a higher tax bracket.

Tax-loss harvesting can be used to mitigate your property gain. This strategy involves selling other capital assets, such as stocks or bonds, that have decreased in value. Short-term losses are first deducted against short-term gains, and long-term losses against long-term gains, before being used to offset the other type of gain. If your capital losses exceed your capital gains for the year, you can use up to $3,000 of the excess loss to offset your ordinary income.