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This recurring sponsored question-and-answer column is written by Eli Tucker, an Arlington-based real estate agent and Arlington resident. Please email him your questions for inclusion in future columns. Video summaries of some articles can be found on YouTube on the Eli Residential channel. Enjoy!

Ask: Do I need to buy another home after selling my current home to avoid paying taxes?

Answer: I often talk to people who confuse two different concepts of property taxes – the capital gains tax exemption and the 1031 exchange. Misunderstanding these two very different concepts can lead to improper planning and avoidable mistakes, so in this column I’ll help you understand the difference.

One is for the primary residence, one for investment properties

The most basic difference is that the capital gains tax exemption applies specifically to the sale of a current or former (details on former are below) primary residence, and the 1031 exchange applies specifically to the sale of an investment property.

One requires the purchase of another property, the other does not

I often hear people confuse what they need to do with the proceeds from a property sale to qualify for the tax benefit. To benefit from a 1031 exchange (investment property), you must purchase another like-kind investment property shortly after the sale is completed. The capital gains tax exemption benefits are granted at the time of sale, regardless of what you do with the proceeds or whether you ever purchase another property again.

Capital gains tax exemption when selling a primary residence

The capital gains exemption allows homeowners to exclude a significant portion of the gain from the sale of their primary residence. For individuals, up to $250,000 in capital gains tax can be excluded. For married couples filing jointly, the exemption doubles to $500,000. The gain is calculated by subtracting your cost basis in the property (original purchase price, capital improvements, selling expenses) from the sale price.

Qualification criteria

  • Ownership/Use Test: The house must have been your primary residence for at least two of the five years before the sale. These years do not have to be consecutive. In practice, this means that if you rent out your house after moving out, you will lose the capital gains tax exemption if you rent it out for 3 years or more.
  • Frequency: This benefit can be claimed every two years.

Special considerations

  • Partial exclusion: If you do not meet all of the ownership/use tests, you may still be eligible for a partial exclusion in certain circumstances, such as a change of job, health problems or unforeseen circumstances.
  • Home office deduction: If you claimed a home office deduction, you must include that portion of your home’s value separately when calculating your gain.
  • Improvements and Selling Expenses: Keep records of all improvements and selling expenses on your home, as these can be added to your cost basis, reducing your capital gain.

1031 Exchange for the sale of an investment property

While the capital gains tax exemption applies to primary residences, the 1031 exchange is an effective tool for real estate investors. Named after Section 1031 of the Internal Revenue Code, this strategy allows investors to defer paying capital gains taxes on investment properties if they reinvest the proceeds in a like-kind property.

Qualification criteria

  • Like-kind property: The properties involved in the exchange must be like-kind, which generally means both investment and commercial properties. The definition of like-kind is quite broad and allows for flexibility in the types of properties exchanged.
  • Timed coordination:
    • Identification Period: You must identify potential replacement properties within 45 days of the sale of your original property.
    • Exchange Period: The purchase of the replacement property must be completed within 180 days of the sale.
  • Use of an intermediary: You must use a qualified intermediary to handle the transaction. This intermediary will facilitate the exchange by keeping the proceeds from the sale of the original property and using them to purchase the replacement property.

Special considerations

  • Reclaiming Diminished Value: If you eventually sell the replacement property without another 1031 exchange, you will have to pay taxes on the diminution in value of the original property.
  • Higher basis: With the tax deferral, your basis in the new property will be lower, which could result in higher capital gains taxes if you later sell it.
  • Estate planning: Heirs may benefit from a step-up in basis to market value at the owner’s death, potentially eliminating deferred gains.

Contact a tax advisor

It’s important to consult a tax advisor to make sure you understand the tax implications or benefits of owning or selling property, especially during or after major life events such as a divorce or death. A tax advisor can provide tailored advice and help you navigate these complex rules so you can make the most financially beneficial decisions.

If you want to talk about buying, selling, investing or renting, do not hesitate to contact me at (email protected).

If you would like to have a question answered in my weekly column or would like to talk about buying, selling, renting or investing, please email (email protected). To read my older posts, visit the blog section of my website at EliResidential.com. Call me directly at (703) 539-2529.

Video summaries of some articles can be found on YouTube on the Eli Residential channel.

Eli Tucker is a licensed real estate agent in Virginia, Washington DC and Maryland at RLAH Real Estate, 4040 N Fairfax Dr #10CA

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