When you sell your home, capital gains of up to $250,000 are tax-free ($500,000 if you’re married). However, many home sellers have capital gains that exceed the $250,000 or $500,000 federal exemptions.
In order to avoid tax on such large gains, you can use a tax-deferred exchange, permitted under Section 1031 of the tax code. Here’s how to do it:
* Move out of your principal residence and rent it to tenants. The tax law doesn’t specify the minimum rental time.
* Then, sell the house as a rental property. A third-party intermediary can hold the sales proceeds, which can be used to acquire another investment property. If you follow the rules spelled out in the tax code, no tax will be due.
Similarly, if you own a second home that cannot qualify for the principal residence tax exemption, the best way to avoid tax is to convert it to a rental property before selling. Then use a tax-deferred 1031 exchange.
You might wish to use the exchange to acquire a residential rental property, which will eventually become your personal residence or a second home. Some tax advisors suggest renting the replacement property for at least 12 months before converting it to your personal residence by moving in.
