Part 1: How to Avoid Capital Gains Taxes When Selling Your Home

Bay Area single-family home values have approximately quadrupled over the past 25 years. In 1999, the average single-family home in San Mateo County sold for around $600,000. Today, the average price has risen to $2,500,000, reflecting significant growth in communities such as San Carlos and Redwood City. While this increase is beneficial for those who purchased their homes many years ago, many long-term homeowners feel constrained by the capital gains taxes they would incur if they sold their properties today. Therefore, it is crucial for homeowners to understand how to minimize or avoid capital gains taxes when selling their homes.

Over the past 25 years, the average single-family home has appreciated by $1,900,000. Even with a $500,000 exemption for a married couple, $1,400,000 remains subject to taxation. Between capital gains and state taxes, a married couple who bought a home 25 years ago would likely face a tax bill of around $500,000 (approximately 35%). The prospect of a $500,000 tax bill leaves many homeowners feeling paralyzed.

There are two common methods to reduce or completely avoid capital gains taxes. Here, we will focus on the first strategy: avoiding the taxes entirely.

Strategy #1: Avoid Capital Gains Taxes

A 1031 Exchange is a tax rule that allows investors to sell their investment property and purchase another investment property without paying taxes, regardless of how much the property has appreciated in value. Here’s how you can apply this strategy if you are currently living in your home:

1. Rent Out Your Home: Move out and rent your home for approximately 2 years. During this time, you may need to rent another home for yourself.
2. Sell and Purchase: After renting your home for 2 years, sell it and buy another property. The new property must also be rented out for about 2 years.
3. Move In: Once the new property has been rented for 2 years, you can move in and make it your primary residence.

Important Points About 1031 Exchanges:

1. Strict Timelines: The IRS has strict timelines that must be followed between selling the old home and purchasing the new property.
2. Use a 1031 Intermediary: You must use a 1031 intermediary, as you cannot receive the sale proceeds directly.
3. Equal or Greater Value: The property you purchase must be of equal or greater value than the one you sold. Otherwise, you will pay taxes on the difference.
   • For example, if you sell your home for $2,500,000 and buy a new one for $2,100,000, you will pay taxes on the $400,000 difference. Alternatively, you could sell your $2,500,000 home and buy two or three homes in a less expensive area, with the combined value being equal to or greater than $2,500,000. You can then move into one of the new homes as your residence and keep the others as investment properties.

Additional Considerations:

• Property Management: Being a landlord can be challenging, but you can hire a property manager to handle the rental for you. This service typically costs around 8% of the rent and is tax-deductible.
• Future Capital Gains: If you decide to sell the new home later, capital gains taxes will apply. However, if you keep the home until you pass away, under current tax rules, your heirs may be able to sell it without having to pay taxes.

Using a 1031 Exchange can be a complex but effective way to defer capital gains taxes and strategically manage your real estate investments.

Taxes Could Increase Significantly

The Biden administration is proposing raising the top capital gains tax rate from 20% to 40% for individuals earning over $1,000,000. With state taxes and an increase in healthcare taxes, overall capital gains taxes in California could reach up to 58%. This means that instead of paying approximately $500,000 in taxes, as in the previous example, you could face a tax bill of around $890,000.

Risk to 1031 Exchanges

The 1031 Exchange strategy, which allows you to defer capital gains taxes by swapping properties, has been effective for many years. However, there is uncertainty as the Biden administration is considering eliminating 1031 Exchanges. You might start the process of renting out your home only to discover that this strategy is no longer available. If that happens, you could still choose to move back into your property or explore other tax reduction strategies, such as the Capital Gains Reduction Strategy #2, which will be covered in our next blog.

Contact Us Today

If this situation concerns you, contact us to develop a strategy tailored to your needs. These tax strategies require the expertise of specialized professionals, and we can connect you with the right experts to assist you.

Please consult with your accountant to understand how a 1031 Exchange might impact your specific tax situation and to stay updated on tax rule changes, which frequently occur.

About the Author

Know more about Mark and Viv of Vabrato Real Estate