You’ve been holding onto that residential investment property for a while now, and suddenly you’re wondering if it’s time to let it go. Maybe you’re tired of being a landlord, or that vacation home isn’t getting the use it once did. Or perhaps you’ve noticed the real estate market in your area is on fire, and you’re thinking, “Maybe I should cash in.”

Whatever your reason, selling an investment property is a big decision that can significantly impact your lifestyle and financial future. It’s exciting, but let’s be honest – it can also be a bit overwhelming. Don’t worry, though! We’re here to walk you through the pros and cons of why you might want to sell, what to consider before you do, and how to navigate those pesky capital gains taxes.

Getting Started with Selling Investment Property

How to avoid capital gains tax on real estate:

You can’t avoid it but there are several strategies you can use to reduce capital gains tax on residential investment property.

• Use Section 121 of the tax code to exclude $250,000 of profit or $500,000 if you’re married, if the property was your primary residence for two of the last five years.

• A 1031 exchange allows you to defer paying taxes on the gains if you reinvest into another qualifying investment property within a strict, specified time frame.

• DST funds let you reinvest proceeds from the sale of your property without buying another property directly.

Tax Loss Harvesting allows you to offset capital gains by selling other investments at a loss.

 

What are the Section 1031 rules?

A qualified intermediary must hold the proceeds from the sale while you search for a replacement property.

You're not allowed to accept the proceeds directly.

The new property must typically be of equal or greater value to the one you sold.

You have 45 days from the sale of your property to identify a replacement.

The transaction must be completed within 180 days.

 

Why Sell an Investment Property?

There are several common reasons why we see folks selling their investment properties. Get clear on your motivations so you can make the right decisions based on current market conditions and what suits your broader financial plan. 

  • Lifestyle Changes: As you and your family get older, your needs, preferences, and your tolerance for real estate woes will likely change (along with your hair and hearing ;). Your property just may not fit your situation any longer. Maybe you’re tired of dealing with tenants and don’t want to manage a rental property anymore, or maybe your vacation home isn’t being used as much as you’d hoped. Perhaps you just want to free up some resources for new opportunities. Downsizing or selling off a property can not only simplify your life, it can leave you with fistfuls of cash that you can put towards a new adventure.
  • Financial Needs: You might currently be facing financial demands that you hadn’t planned for. Perhaps you’re looking to travel more in retirement, are looking to help pay for your kids’ or grandkids’ education, or are just looking to provide a cushion for future unknowns, like the possibility of  increasing healthcare expenses. Monetizing your second home can provide you with more liquidity to address these concerns. 
  • Favorable Market Conditions: Sometimes you just need to strike while the iron’s hot. Chances are you’ve seen the value of your vacation home substantially increase since you’ve owned it. While you might not be sure of your next move, perhaps you’re just feeling tempted to cash in while you can. 

Tax Strategies: How To Reduce Capital Gains Tax

The lucrative sale of an investment property in a hot market is exciting, but the capital gains tax is significant, so you want to get ahead of that. Fortunately, there are strategies to manage capital gains taxes efficiently.

  1. Section 121 Exclusion: If you used the property you’re selling as your primary residence for at least two of the last five years, you can exclude up to $250,000 ($500,000 for married couples) of capital gains. This is an automatic exclusion provided for by the tax code. Just be sure to keep track of any additions or renovations to the property so that you can add those costs to your tax basis and lower your gain.
  2. 1031 Exchange: Defer taxes on any gains made in the sale by reinvesting proceeds into another qualifying investment property.
  3. Tax-Loss Harvesting: Balance gains by selling other investments at a loss.

Remember, these strategies have specific rules and limitations. 

Though these tax strategies can save you money, they shouldn’t be the sole driver of your decisions. You don’t always want the tax tail to wag the dog.  

Use Section 121 of the Tax Code: $250K / $500K Tax-Free

If you’ve lived in a property for two out of the last five years, then you’re eligible for the Section 121 exclusion. As a single taxpayer, you can exclude up to $250,000 of that gain, and if you’re a married couple, it’s $500,000. The IRS only counts the years the property was your primary residence. This exclusion is available every two years. 

It’s important to note that this exclusion is prorated based on how long you have owned a property and for how many of those years it was your primary residence. For example, if you owned a home for 10 years, but it was only your primary residence for 2 of those, you are only eligible for 20% of the exclusion. Each additional year that the property is your primary residence will help you gain additional capital gains exclusion, but you will not get 100% of it if the property was not your primary residence for 100% of the time you owned it.

Leverage Section 1031 of the Tax Code

A 1031 exchange is a provision that allows you to defer the taxes on the gains made from the sale of your property as long as you purchase another investment property with those funds within a certain period of time. It provides a valuable opportunity through what’s called a “like-kind” exchange. To take advantage of this provision, it’s important to know and follow the rules and strict timelines.

  • A qualified intermediary must hold the proceeds from the sale while you search for a new property.
  • You’re not allowed to accept the proceeds directly.
  • The new property must typically be of equal or greater value to the one you sold.
  • You have 45 days from the sale of your property to identify a replacement.
  • The entire transaction must be completed within 180 days.

Though the rules may evolve over time, Section 1031 remains a powerful tool for deferring taxes while reinvesting in other income-generating properties. Working with professionals like attorneys who specialize in 1031 exchanges can help you meet the requirements and fully benefit from this tax-deferral strategy.

Tax-loss Harvesting: Offset Capital Gains

Tax-loss harvesting is another effective strategy for reducing capital gains taxes when selling a property. It’s particularly useful for individuals with a diversified portfolio. This approach allows you to offset gains from a profitable sale by selling other investments at a loss. Balancing gains with losses can make a significant difference in your tax bill.

Alternative Investment Options: DST Funds

A unique alternative to traditional 1031 exchanges is a Delaware Statutory Trust (DST) fund which allows you to reinvest the proceeds of a property sale without directly buying another property. The benefit is that you’re not tied to a specific property that you need to manage anymore. This makes DST funds appealing for those wanting to defer taxes on a property sale without the responsibility of managing new real estate.

DST funds are relatively new, but offer flexibility if you’re looking to defer taxes and unburden yourself from property management. Be aware, however, of liquidity restrictions with DST investments. They can limit easy access to funds for immediate needs like retirement income or education expenses.

Final Thoughts

Selling a residential investment property is a significant decision that can impact your lifestyle, finances, and long-term goals. While there are compelling reasons to sell, we recommend approaching this decision holistically.

With several powerful strategies to limit the amount you owe in capital gains taxes, it’s important to remember that offsetting your tax liability shouldn’t be the basis of your decision-making process. 

Paying some taxes on a profitable investment isn’t necessarily a bad thing. It means you’ve made a successful investment. Focus on your overall financial goals and quality of life considerations when deciding whether to sell a property.

Ask yourself:

  • How does this property fit into my current lifestyle and future plans?
  • What are my long-term financial objectives, and how does this property align with them?
  • Am I prepared for the responsibilities and potential challenges of property ownership or management?

Whether you decide to sell, hold, or explore alternative investment options, the most important factor is that your choice supports your vision for the future. Working with qualified legal counsel, real estate professionals, and financial advisors can help you clarify your motivations, consider market conditions, and leverage appropriate tax strategies.

At SK Wealth, our financial advisors have been helping clients make informed choices about investments for 25 years. We’ve honed our financial planning process, The Integrated Financial Advantage™, in order to offer recommendations that are personal to you, your lifestyle, and your goals so that you can live with intention, tomorrow and today.

Click here to find out more about SK Wealth’s specialized financial planning and investment management services.

Mackenzie Richards

Author Mackenzie Richards

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