How to Reduce Capital Gains Tax on a Home Sale

You will owe capital gains tax on a home sale if you profit on the transaction. This profit is treated similarly to how income is by the Internal Revenue Service (IRS). The special category of income called "capital gains" applies to income on investments such as stock, bonds and property transactions. There is no way to avoid paying this tax all together. Avoiding the necessity to pay either income or capital gains tax is considered a crime in the United States. That said, there are ways to legally and ethically reduce the sum you owe to capital gains on a real estate transaction.

1031 Exchange Options

The most common option used to reduce and defer capital gains tax is called a 1031 exchange. This method is entirely legal; in fact, it is a part of the IRS code. With this option, the earnings gained through the sale of one property are directly applied to the down payment required to invest in a new property. Instead of actually "cashing out" the equity from your home sale, then, you are simply reallocating it to a new investment.

The requirements for a proper 1031 exchange are very detailed. First, both properties must qualify under IRS regulations. To learn if your properties qualify, consult your real estate agent. The transactions must also take place simultaneously so you do not cash out any of the profits. When you sell the new property, you will have to pay tax on all of the gains you earned from both investments.

Deferred Sales Trust

A deferred sales trust (DST) is another way to defer the payments you will be charged for capital gains. Instead of collecting the entire gain all at once, you can choose to have the profit placed in trust and then paid out over time. The length of time is established at the point the trust is set up. 

With this model, you may choose to operate your trust like a business, and you may even incorporate the trust to make it a Limited Liability Corporation. This is particularly useful if you own multiple properties. Then, capital losses can be deducted from gains in a given year, reducing the taxes you owe.

Capital Gains on a Secondary Property

It is important to realize that capital gains and capital loss tax laws apply to investment properties, not primary residences. A home qualifies as a primary residence only if listed as such for more than two years. IRS code does change over time. However, as of May 2010, it states that up to $250,000 in profit on a primary residence can be excluded from taxes. 

If you live in multiple homes, you will need to reside in a home for at least 24 months out of 5 years in order to call it a primary residence. This means you could potentially have two separate primary homes within any 5-year period. Keep these regulations in mind as potential methods to reduce the income tax imposed on you in a given period. For this reason, multiple property investments can often present unique tax advantages over other forms of investment.