There are two things in life that are certain: death and taxes. And if you’re about to sell a property, then you know what’s coming next: capital gains tax.
In the context of real estate, capital gains taxes are taxes that you owe for profits you make from the sale of a property. Homeowners may be aware of how to use capital gains tax exclusions and 1031 exchanges to their advantage, but there’s a way to save even more by utilizing both.
First things first:
What does Section 121 do?
IRC Section 121 allows $500,000 in capital gains tax exclusions for married homeowners on their primary residence and $250,000 in exclusions for single homeowners, meaning that the first $250,000 or $500,000 in profit that a homeowner makes on their primary residence is exempt from any California or federal tax.
To qualify for this exemption, you must have:
1. Owned the property for at least two years;
2. Used the property as your primary residence for at least two of the past five years;
3. Cannot have used the Section 121 exclusion in the past two years;
This effectively means that you can rent your home for up to three years and still pocket the $250,000 or $500,000 exemption.
For example, if you and your spouse purchased your home for $500,000, meet the aforementioned requirements, and sell it for $1 million, you will not owe any capital gains tax because the gains in this instance amount to $500,000, which is the exempt amount for married homeowners under Section 121.
How does a 1031 exchange work?
If you’re selling in Silicon Valley — where average home prices run in the millions — and looking to keep more profits with the sale of your home, you may still face a hefty capital gains tax, despite the Section 121 exclusion. This is where a 1031 exchange can be used to your advantage.
The 1031 exchange, named after IRC Section 1031, involves an exchange of one investment property for another of equal or higher value. Since an owner is placing any profit received from the sale of one investment property into the purchase of another, the rationale is that the owner does not need to pay capital gains tax because they have not cashed out any of the “gains” made.
There is no limit to how many times an owner can defer their capital gains taxes through this exchange method; the capital gains tax will only be due when the owner eventually sells their investment property for cash.
How can both Section 121 and a 1031 exchange be used to my advantage?
If you rent out a property for a year or more, it may qualify as an investment property eligible for a 1031 exchange. This means that if you have both lived in that property as your primary residence for at least two years and later rented it out, it can qualify as both a primary residence and an investment property. A homeowner can pocket the untaxed $250,000 or $500,000 that you gained from the sales proceeds (via IRC 121), and ‘roll’ the remaining proceeds into an investment property and pay nothing in capital gains.
Let’s say you’re a single individual who purchased a townhome in Cupertino for $500,000 in 2005 that is now worth $1.5 million. If you sell the property immediately after living there as your primary residence, your tax base will be $500,000 and you will be exempt from $250,000 under Section 121. However, you will be responsible for paying capital gains tax on the remaining $750,000. At a 33.3% tax bracket (20% top federal capital gains bracket, 13.3% top CA bracket), you as the seller would have to pay $249,750 to the federal and state government in taxes.
Instead, if you rented your home for at least a year before selling, you can use the
$249,750 that you would have owed in taxes and invest that money into another investment property in any state. Depending on where you’re looking to purchase, that money could be enough to buy a property outright without financing or used toward a down payment on a single-family home or duplex.
What’s the catch?
There are timing considerations to keep in mind when conducting a 1031 exchange and managing a rental property, especially one that is far from where you live and be a lot of work. Additionally, conducting a 1031 exchange means you may still pay capital gains taxes at a later date (although we have strategies for that as well).
That being said, each situation is unique and it’s always best to consult with your CPA/attorney before making any big financial decision. Luckily, the Kei Realty Group is composed of attorneys with tax and real estate backgrounds and we have successfully implemented various strategies for numerous clients in the past. Chances are there are several ways to achieve your real estate and financial goals, so don’t hesitate to reach out if you have any questions. We’re always happy to chat more about your specific needs and questions at 408-472-4127 or by email at email@example.com.
Proposition 19, which passed in the November election by a slim majority in California, will implement a number of key changes to how you can — or can’t — retain your property tax benefits after selling or transferring your home.
Major provisions in the legislation begin going into effect February 2021, but Prop. 19 won’t impact everyone buying a new home.
Here’s what you need to know:
If you’re 55 and older, lost your home to a natural disaster, or have a severe disability
Moving just got a little bit easier for you.
Beginning on April 1, 2021, Prop. 19 will allow homeowners aged 55 and older, those who lost their homes to a wildfire or natural disaster, or those who have a severe disability to move anywhere in California and retain their existing property tax benefits up to three times, so long as that property is “purchased or newly constructed as that person’s principal residence within 2 years of the sale of the original primary residence,” according to the legislation.
For example, if you originally purchased your home for $400,000 and it is now worth $1.3 million, you may now retain your $400,000 tax base if you purchase or newly construct a home that is worth $1.3 million or under anywhere in the state of California.
If you fall under this category and your new home purchase is more expensive, Prop. 19 will also give you some leeway in tax savings by allowing you to blend the taxable value of your old home with the sale price of the new home. To calculate this new value, take the difference between the sale price of your original primary residence and the purchase price of the new home, and add it to the tax basis of the original primary residence.
To use the example from earlier: If your original primary residence was first purchased for $400,000 and is now worth $1.3 million, but you want to move to a home that is worth $1.5 million, you will retain your $400,000 tax base for the first $1.3 million of the value, while the remaining $200,000 will be added to the original $400,000 resulting in a $600,000 property tax base.
Prior to the passage of Prop. 19, homeowners had one opportunity to retain their existing tax benefits if they moved to a home in the same county, or a specific list of 10 counties, that was equal or lesser in value than the home they just sold. If they moved to a different county, one outside the list of 10, or to a more expensive home, they would lose their existing tax base and end up paying more in property taxes.
If you’re a parent passing down your home to your children, or you’re a grandparent passing down to grandchildren whose parents have died
The level of concern you should have for Prop. 19 boils down to what your child decides to do with the home you’ve passed on to them.
If your child will be living in that home as their primary residence within one year of the transfer, then you don’t have to worry about too much. The transfer will not trigger a reassessment, so long as the difference between the assessed value and the current market value is not greater than $1 million. If the difference is greater than $1 million, the home will be partially reassessed — but not at market value.
If, however, your child does not plan on living in that home full-time as their primary residence (e.g., they want to keep it as a second home or rent it out), your child will not be able to retain your existing tax benefits. For all transfers taking place beginning February 16, 2021, the home will be reassessed at its market value and the property taxes will likely increase as a result.
This may come as a disappointment to children inheriting property, as previous legislation prior to the passage of Prop. 19 allowed children to maintain the tax base value for inherited property, regardless of how they used the property. But Prop. 19 will not be retroactive, so it will only apply to transfers taking place beginning February 16, 2021.
These same rules apply to grandparents who are passing down family homes to grandchildren if their parents have died.
No worries — you’re likely not the only one! Feel free to reach out to us to chat more about your specific needs and questions in the contact form below.
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