If you sell your home for more than what you paid, you may have to pay capital gains tax. However, if you sell your main home and make a profit, you can exclude some of that profit from your income if you meet certain requirements. The home has to be your principal residence. Investment properties are not considered principal residences and are taxed differently than primary residences.
If you’ve owned a home for five years and lived in it for two years, you can exclude up to $250,000 for an individual or $500,000 for a married couple. The two years don’t have to be consecutive years. The home must have been your principle residence for a total of two years within the five years. You can claim this exclusion once every two years if you sell or exchange your primary residence often.
There are a few exceptions to this rule. If you lived in your home less than two years and need to sell because the location of your job changed, health concerns or other unforeseen circumstances, you can exclude a portion of the gain. You will need to show proof which meets either of the exceptions, if the IRS asks you for it. Job location change and medical concerns are self-explanatory. The IRS publication 523 defines and unforeseen circumstance as “the occurrence of an event that you could not reasonably have anticipated before buying and occupying your main home.” Specific examples include: natural disasters, acts of war, acts of terrorism, change in employment or unemployment that left you unable to meet basic living expenses, death, divorce, separation or multiple births from the same pregnancy.
There is no exemption for capital gains tax on the sale of investment homes. Yet, the 1031 tax exchange allows you to sell your property and defer your capital gains tax. It allows you exchange one investment property for another. You must purchase a replacement that is of equal or greater value in order to qualify for the 1031 exchange.
When you sell your property, you need to state that you’re using the 1031 exchange in the sales contract and a qualified intermediary must hold your proceeds until you close on your new investment property. You have 45 days to identify the replacement property.
You need to identify three or more properties as your replacement to avoid paying capital gains taxes. If you don’t close on either of the properties you identified, you will be required to pay capital gains tax. You have 180 days following the sale of your property to buy the replacement.