10 Savvy (And Legal) Ways To Avoid Capital Gains Tax on Real Estate

When you sell a property you own, the profit you earn is considered a capital gain. In some cases, you might have to pay taxes on this gain.

Although long-term capital gains — which involve owning something for more than a year — are taxed more favorably than standard income, they still amount to money out of your pocket. Depending on the situation, your tax bill can be substantial.

Luckily, you can employ some thoughtful strategies to lower your capital gains taxes. The following tax-savings options might help you eliminate some money stress.

When you sell an asset such as a piece of real estate, the profit you earn is a capital gain. In many cases, you have to pay a capital gains tax on this windfall. The rate of the tax varies based on both how long you held the asset and your income.

Short-term capital gains taxes apply to the profit from assets that you held for one year or less. If you held the asset for a year or less, the profit typically is taxed at the same rate as your ordinary income.

Long-term capital gain taxes apply to the profit from assets that you held for more than one year. Long-term capital gains are taxed more favorably. In most cases, you will pay either 0%, 15%, or 20% on the capital gain, with the percentage being determined by your taxable income for the year.

Here are some ways to avoid paying — or to at least reduce — capital gains tax on real estate.

If you are a single person who sells your primary residence, you may qualify to exclude up to $250,000 of that capital gain from your tax bill. For married couples filing jointly, the exclusion amount increases to $500,000.

In order to qualify for this tax break, you must have lived in the property as a primary residence for at least two of the previous five years.

Homeowners who sell their property and keep the capital gain under this threshold will not owe capital gains taxes.

As we have mentioned, if you live in the house for at least two of the last five years, you might qualify for a capital gains tax exclusion.

So, let’s say you own a home before moving out and renting it for three years. In the fourth year, your tenant moves out and you move back in.

You have now lived in the home for two of the past five years and would qualify for the capital gains tax exclusion.

Homeowners who want to pursue the capital gains tax exclusion cannot do so if they already have claimed such an exclusion during the previous two years.

So, you will need to make it past the two-year mark before you can sell the home and use the capital gains tax home sale exclusion option again.

Here is another scenario: You buy a rental property and keep it occupied with tenants for 20 years. Then, you stop renting out the building and move into it yourself.

Once you have lived in the property for two years as your primary residence, you will qualify to shield as much as $500,000 in profit from capital gains taxes, depending on your tax-filing status.

Just as you can move into a rental property for two years to qualify for the capital gains exclusion, you can do the same thing with a vacation home.

So, if you keep a primary home in the city and a vacation home at the lake — both for 10 years — you could sell the primary home and get the capital gains tax exclusion before moving into the lake home full time.

After a few years, you could then sell the lake home and also get a capital gains exclusion even if the home was not your primary residence for the majority of the time you owned it.

When you inherit a home, you’ll generally receive a “step up in basis.” This means that for tax purposes, the value of the home will be adjusted to its fair market value at the time of the inheritance. In essence, this wipes out the gain for tax purposes and starts you over at ground zero.

For example, let’s say your parents bought a home for $100,000 that appreciated to $700,000 at the time of the last parent’s death. If you inherit the property, you will receive a step up in basis to the fair market value of the home — in this case, $700,000.

If you turned around and immediately sold the home for $700,000, you would owe nothing in capital gains taxes. Without the step up in basis, you would have owed capital gains taxes on $600,000 worth of profit.

If you were recently widowed, you might still qualify for the capital gains tax exclusion of $500,000, which is generally available only to married couples filing jointly.

In order to qualify, you must sell your home within two years of your spouse’s death, remain unmarried and have lived in the property for at least two of the previous five years.

If you have a second home, you could choose to rent it out to help cover expenses, including capital gains taxes.

Although this strategy won’t necessarily lower your capital gains taxes when you sell, the rental income you generate could help offset the cost of the capital gains taxes.

If you are an investor planning to reinvest the proceeds of the sale into a similar property, a 1031 exchange can help you defer the tax bill until later.

If you don’t follow the precise rules of a 1031 exchange to obtain a similar property, you might get stuck paying capital gains taxes. So, you might want to consult with a tax professional or other financial expert before pursuing this route.

A special situation, like a divorce or military transfer, could make you eligible to pay less on the capital gain generated from a home sale.

The details vary significantly based on your situation. So, consider talking with a tax professional if you want to find out if you qualify for one of these special situations — and the tax break.

Capital gains taxes can add up quickly. Fortunately, homeowners who know the rules can often map out a plan to avoid paying too much in such taxes.

As you build wealth, learning the rules of the tax code can help you make the most of your resources.