When you sell your primary residence, you may be able to take advantage of a special exemption that allows you to avoid paying capital gains taxes on the sale. When dealing with a rental property, this exemption may not apply, depending on your situation. Before selling a rental property, consider the tax implications of doing so.
Capital Gains Tax Exemption
The rules involving the capital gains tax exemption may allow you to get out of paying capital gains taxes on a property that you live in. However, if the property is a rental when you sell it, the exemption will not apply. According to the rules for this exemption, you have to live in the property for two out of the last five years and you must be living in the property when you sell. If you qualify, you can avoid up to $250,000 of capital gains taxes as an individual or avoid $500,000 as a couple.
Turning Into Primary Residence
If you know that you want to sell a rental property, you could turn it into your primary residence to avoid the capital gains tax exemption. For example, if you lived in the house for a year originally before turning it into a rental property, then rented it out for three years, you could move in for the final year and get the exemption. The dates in the house do not have to be sequential as long as you are living in the house when you sell it.
If you cannot move into the property and you still need to sell it, one way to potentially avoid capital gains taxes is to participate in a 1031 exchange. With a 1031 exchange, you can sell the property and then use the money from the sale to buy another rental property. When you use this process, you do not have to pay capital gains taxes on the money that you earn from the sale of the property.
When you want to use a 1031 exchange to avoid capital gains taxes, you must not touch the money from the sale of your property. You must leave the money with a qualified intermediary. Once you sell your property, you have 45 days to identify some replacement properties. You also have 180 days from the date of the sale to close on a property. If you do not meet these deadlines, you will not be able to use a 1031 exchange to avoid capital gains taxes.