First, a disclaimer. I am not a tax professional, financial planner, or accountant. I sell real estate, not tax advice. However, I can tell you what I know about the above topic and urge you to verify what I say with a tax professional.
The inspiration for this column was a phone call I received from a reader who wanted to confirm that she has to buy a new house within two years in order to avoid paying capital gains on the sale of her primary residence.
Although this hasn’t been the case since the Taxpayer Relief Act of 1997, many homeowners appear to be unaware that the rules have changed, given how often I get this question. Nowadays no capital gains tax is due on the sale of your primary residence unless your gain exceeds $250,000 for an individual or $500,000 for a married couple. (Note: It must have been your primary residence for 2 of the 5 years prior to closing.)
That exemption has been in place now for 20 years. Prior to that, homeowners were required to reinvest in another primary residence in order to defer their capital gains tax until they finally sold without buying a new home.
Your “gain” is calculated from a combination of your purchase price plus any capital improvements you made, plus the cost of selling the house. That’s called your “basis.”
So, let’s say that you bought a home 40 years ago for $50,000, and you’ve made another $50,000 of capital improvements (new garage, new kitchen, new bathrooms, etc.). You just sold the house for $500,000, with a total cost of selling (commissions plus title insurance and other fees) of $25,000. Your “basis” is $125,000, so your gain would be $375,000. If you’re married, you have a $500,000 exemption, so you owe no capital gains tax at all. If you’re single, you have a $250,000 exemption, so you’d pay long-term capital gains tax on $175,000 of your net gain. That computes to a tax liability of about $35,000. You probably had no mortgage, so your proceeds from the sale was about $470,000, and paying $35,000 in capital gains tax is definitely doable. Yes, I realize you’d prefer to pay nothing, so go ahead and marry that cute 75-year-old you’ve been dating before you sell!
If you sell a second home or an investment property, you do pay a tax on your full capital gain, but you can defer that tax liability by purchasing a replacement property under Sec. 1031 of the IRS Code. But this is only a deferral. Your “basis” in your current property becomes the basis for the replacement property, so you do eventually have to pay the tax (unless the tax law changes). Meanwhile, a 1031 exchange allows you to re-invest pre-tax dollars in a new piece of real estate.
Your purchase under Sec. 1031 does have to be for real estate, but it can be any kind of real estate. I once had an $800,000 capital gain on the sale of an office building in Denver. Using a 1031 exchange, I invested $600,000 of that gain in a residential rental property and paid capital gains on only $200,000. However, when I sold that rental several years later without doing another 1031 exchange, I had to pay tax on that deferred gain, although it was reduced by the additional investment and cost of sale.
To do a 1031 exchange, you need to hire a “qualified intermediary,” who holds the proceeds from the sale of your “relinquished” property until you purchase your “replacement” property. This service costs upwards of $1,000, but without it, you can’t do a 1031 exchange, so it’s probably worth it. I would be happy to recommend the company I used for that process.
On a related matter, let me share some tax advice I received regarding passing your property on to a child or other beneficiary. (Again, I’m not a tax advisor, so confirm this with yours.) I was told you should not put your child or beneficiary on the title of your home as a “joint tenant with right of survivorship.” Rather, you should will the home to that beneficiary. Why? Because when real estate is inherited, the basis is “stepped up” to the current market value at the time of your death. If the beneficiary is a joint tenant, he inherits your much lower basis and could owe significant capital gains tax when it comes time for him or her to sell it.
Published June 8, 2017, in the Denver Post's YourHub section and in four Jefferson County weekly newspapers.