Real estate investors often avoid paying capital gains taxes by deferring payments to the IRS through 1031 exchanges. A 1031 exchange allows property owners to take proceeds from the sale of one property. They can use those proceeds to purchase another like-kind property without incurring tax penalties. As long as these two properties are of equal value and all other requirements laid out by the IRS are met, the owner need not pay taxes until the replacement property is sold. When a homeowner sells their property and plans to buy another, they might wonder if a 1031 exchange could help them avoid paying taxes. So when can you do a 1031 exchange for a primary residence? The short answer to this question is “hardly ever.” Unfortunately, most primary residences do not meet IRS requirements for a 1031 exchange. However, homeowners can exclude capital gains tax in other ways. Follow below to learn all you need to know about 1031 exchanges as a homeowner in 2022.
Six Key Terms to Know
#1 Capital Gains and Capital Gains Tax
One cannot understand 1031 exchanges – or any of the other terms in this list – without knowing about capital gains and capital gains tax. According to the IRS, a capital gain or capital loss is “the difference between the adjusted basis and the amount you realized from the sale…of a capital asset.” When one profits off the sale of an asset, they are left with capital gains. For reference, capital assets are pretty much any type of personal property – including houses, furniture, stocks and other investments.
Adjusted basis refers to changes in the cost of a capital asset during ownership. In real estate, improvements made to a property during ownership can increase the adjusted basis. Conversely, depreciation can decrease the basis because it lowers the fair market value of the property when it was originally purchased. A decrease in the basis means the capital gains tax you owe once you sell could go up. Though not in all cases, the IRS often collects capital gains tax on the sale of commercial and residential real estate. There are two main types of capital gains tax: short term and long term. Regardless of whether short term or long term capital gains taxes are due, they cannot be paid until after an asset is sold.
Short Term Capital Gains Tax
Writing for Investopedia in his article “Capital Gains Tax,” Jason Fernando explains both short term and long term capital gain taxes on real property. Fernando notes that “short-term capital gains tax applies to assets that are sold one year or less from the date they were purchased.” In these cases, the profit previous owners make off the sale of their property “is taxed as ordinary income.” For most taxpayers, regular income tax is “a higher tax rate than the capital gains rate.”
Long Term Capital Gains Tax
Profits taxed as long term capital gains are those made after the sale of a property owned for longer than one year. As Fernando explains, “the capital gains tax rate applies only to profits from the sale of assets held for more than a year.” Rates for long-term capital gains tax are currently “0%, 15%, or 20%, depending on the taxpayer’s tax bracket for that year.” In short, long-term capital gains taxes vary “according to a rate schedule that is based on the taxpayer’s taxable income.” Not all homeowners or real estate investors who sell their properties and make a profit will owe capital gains tax. Some are excluded from paying capital gains and others are able to defer capital gains taxes per exceptions outlined in the tax code. We explain this further in our section about the five-year rule.
#2 Five-Year Rule or Two-Out-Of-Five-Year Rule
The five-year rule or “two out of five year” rule allows homeowners to take advantage of a home sales exclusion. In order to claim this exclusion, the homeowner must have lived in their house for at least two of five years of ownership. William Perez explains in his article “Do You Have To Pay Capital Gains Tax on the Sale of Your Home?” for The Balance. Perez writes that some homeowners are eligible for the Section 121 Exclusion – a tax break commonly called the “home sale exclusion.” This section of the Internal Revenue Code or IRC says that “unmarried individuals can exclude up to $250,000 in profits from capital gains tax when they sell their primary personal residence.”
Taxpayers who are married filing jointly are allowed to “exclude up to $500,000 in gains.” This means that if you bought your home – by yourself – for $400,000 but sold it for $600,000, you would not need to report any profit to the IRS as taxable income. However, if you sold that same home for $800,000, you would have to report $150,000 of your profit from the sale on your tax return as taxable income. Major home improvements and closing costs can be added to your cost basis, narrowing the gap between what you paid for your house and what you sold it for.
How the Two Out of Five Year Rule Impacts Eligibility for the Home Sale Exclusion
The five-year rule determines whether homeowners who just sold their property are actually eligible for this tax break. Stephen Fishman, J.D. explains in his article “The $250,000/$500,000 Home Sale Tax Exclusion” for NOLO. Fishman notes that in order “to qualify for the $250,000/$500,000 home sale exclusion, you must own and occupy the home as your principal residence for at least two years before you sell it.” Your former primary residence “can be a house, apartment, condominium, stock-cooperative, or mobile home fixed to land.” According to Fishman, this rule is fairly generous because most Americans live in their homes for at least seven years before selling.
As with many tax rules, Fishman notes that the two-year rule can be confusing – especially for first-time homeowners. To this end, Fishman writes that “ownership and use of the home don’t need to occur at the same time.” Homeowners are eligible for the home sale exclusion as long as they have “at least two years of ownership and two years of use during the five years…the ownership and use can occur at different times.”
#3 1031 Exchange
Next on our list of terms to know is the subject of this post: 1031 exchanges. When applicable, 1031 exchanges allow property owners to avoid paying capital gains taxes upon the sale of a home or commercial property. In his 2019 article “1031 Exchanges Save IRS & State Taxes, Even Leaving California” for Forbes, Robert W. Wood explains. Wood writes that “under 1031, if you exchange real estate for ‘like-kind’ real estate, gain is postponed until you sell your replacement property.”
Certain real estate investors are notorious for strings of 1031 exchanges that defer taxes for decades. In most cases, the property in question must be a business or investment property. It cannot be your personal residence. However, because “like-kind is actually pretty widely interpreted,” there are some exceptions.
How Does a 1031 Exchange Work?
Of course, sellers cannot wait forever to buy a replacement property when doing a 1031 exchange. Wood notes that “the replacement property must be identified within 45 days after the transfer of the relinquished property.” The relinquished property is the property that was initially sold, triggering the 1031 exchange. That seller must close on their replacement property either 180 days after the transfer date or when their tax return comes due. Whichever comes first is the date by which the title for the replacement property must be transferred. From here, the 1031 exchange process becomes a bit murkier and more complex.
Wood explains that “Section 1031 requires relinquished property be exchanged for replacement property.” However, the IRS lets investors use “qualified intermediaries” or QIs. We will discuss this in further detail in future posts. For now, homeowners should know that 1031 exchange rules differ from state to state. As always, homeowners should consult a tax professional if they have any questions.
#4 Like Kind Property
As mentioned above, in order to qualify for a 1031 exchange and deferral of capital gains tax, the two properties exchanged must be “like-kind.” Writing for Investopedia, James Chen explains what “like-kind” means in real estate – and more importantly, what it means to the IRS. According to Chen, “the term like-kind property refers to two real estate assets of a similar nature regardless of grade or quality that can be exchanged without incurring any tax liability.” In most cases, like-kind properties involved in an exchange must be considered real property. This property must be held for business or investment purposes under Section 1031. Because of this, personal residences rarely qualify as “like-kind properties.” Like-kind property must also be located within the United States in order to qualify for a tax deferral.
In his article for Investopedia, Chen lists a few examples of like kind property exchanges that would be recognized under Section 1031. Chen writes that exchanging a “multifamily property for an industrial building” or swapping a “condominium rental for a single-family rental property” would both qualify. Exchanging “vacant land for a medical complex” could also qualify. Keep in mind that the property acquired must be of equal or greater value than that of the property originally sold. One investment property must be of comparable value when compared to the next. The debt you carry on the replacement property and the equity you hold in the replacement property must also be very similar to that which you held in the relinquished property.
#5 Partial 1031 Exchange
In some cases, property owners might choose to do a partial 1031 exchange. Matt Frankel, CFP explains partial 1031 exchanges in his article “What is a Partial 1031 Exchange?” for MillionAcres. First, Frankel reiterates that “a 1031 exchange allows you to defer all taxation by reinvesting the sale proceeds in a new property.” Next, he notes that one need not use all the proceeds from a sale to fund a like-kind purchase. According to Frankel, “you can choose to take some money off the table upon the sale of an investment property while still deferring the majority of your tax liability.” This is what the IRS refers to as a “partial 1031 exchange.”
The IRS usually requires both investment properties in a 1031 exchange to carry equal debt, equity and value. However, this is not always the case. Frankel writes that “it’s possible to buy a property for less than the original property’s sale price or with a mortgage that is less than the balance owed at the time of the sale” while still deferring taxes. There could be a difference between the sale price of the relinquished property and purchase price of the replacement property. If the amount you paid was less than what you made, you must pay taxes on what the IRS calls “boot.” One cannot defer capital gains taxes related to “boot.”
For example, if you buy a property for $300k, but the net proceeds of your relinquished property were $350k, you would pay capital gains taxes on that difference of $50k. You can use that $50k – minus any taxes owed to the government – for other expenses unrelated to your property exchange. Some choose to invest the money from a partial tax deferred exchange in another property while others use it for personal expenses.
#6 Rollover Rule
Our next term is the “rollover rule,” which was repealed in 1997 as part of the Taxpayer Relief Act of 1997. The rollover rule allowed homeowners to defer capital gains tax when they sold one home and bought another. In many ways, the rollover rule was comparable to the 1031 exchange – except that it applied to primary residences instead of investment properties. In his article “A capital-gains rollover in your past can haunt you in the future” for The Washington Post, Benny L. Kass explains.
Kass writes that “the rollover allowed homeowners who sold a principal residence to defer tax on any profit if they purchased a new home within two years at a price equal to or greater than the sales price of the old one.” Today, homeowners can avoid paying capital gains tax on a certain amount of profit per the Home Sale Gain Exclusion rule. This rule allows homeowners to exclude rather than defer capital gain taxes.
When Can You Do a 1031 Exchange on Your Personal Residence?
Most homeowners will simply take advantage of the home sale exclusion rule rather than trying to do a 1031 exchange when selling their prior home and buying a new one. However, there are certain circumstances under which one can defer capital gains with a 1031 exchange of a primary residence. Matt Frankel, CFP explains in his article “The 1 Time a 1031 Exchange for Your Primary Residence Makes Sense” for MillionAcres. Frankel notes that “a 1031 exchange generally only involves investment properties.” As such, “your primary residence isn’t typically eligible for a 1031 exchange.” The vacation home you live in a few months of the year probably isn’t either. However, rental property owners might be able to use both the primary residence exclusion rule and a 1031 exchange to their advantage.
Frankel describes a scenario in which a property owner wants to sell an investment property but knows they would owe a lot in taxes. However, that property owner could sell their property, buy another rental property and later convert it into a primary home. In doing so, they could defer capital gains tax when purchasing the second property through a 1031 exchange. If the owner later sells the property they converted into their primary residence, they could claim the home sale exclusion. Of course, the property owner would have to pay some deferred taxes eventually. On the flip side, they could “avoid paying some of [their] capital gains tax entirely.”
Final Thoughts on 1031 Exchanges for Primary Residences
Of course, the IRS strictly regulates 1031 exchanges. As such, property owners must consult with a tax professional before trying to take advantage of “loopholes” such as the one described above. Given that 1031 exchanges are not possible for most homeowners, claiming the home sale exclusion is usually the best way to avoid taxes. In general, the primary residence exclusion offers homeowners a generous tax break.
Homeowners filing as single taxpayers need not pay any capital gains up to $250k. Married homeowners filing jointly avoid capital gains taxes up to $500k. For information about which forms to file regarding the sale of your home and any taxes owed, read this resource from the IRS.