How can we minimize capital gains taxes when selling rental property?

If my wife and I sold a rental property for $150,000 and purchased a new property for $300,000, how would we avoid capital gains taxes? I am aware of the 1031 exchange option, but we want the new property to be our primary residence. Could we rent it for a period of time before living in it? How long?

Co-Published on Investopedia

Co-Published on Investopedia

It is possible to avoid paying taxes using a 1031 exchange option. Your thinking is correct, you would need to buy the new property and keep it as a rental for a period of time. But you must be careful the IRS doesn't see your actions as being taken for the sole purpose of avoiding capital gains taxes. There is no clear guideline (that I'm aware of) regarding the length of time for renting the property out for this to work.

Another wrinkle is if you have already sold the old property, the 1031 exchange is no longer available. The exchange must be in place prior to the sale of the old property. But let's assume you still own the old property and are planning to sell it.

Get Professional Help

This is a question you will need your CPA (or tax attorney) to answer, because your tax advisor is going to be the one filing the future tax returns with their name on it. Ultimately, you want your CPA to be comfortable with the time period and strategy, as acting under the guidance of your qualified tax advisor will partially protect you if the IRS challenges the transaction.

If you don't have a CPA, now is the time to get one. Also, if your CPA doesn't bless the transaction, don't go looking for another CPA who will. The IRS and tax courts have routinely rejected claims of acting under the guidance of a tax advisor when the client shopped around for advice they wanted to hear.

Look for legal precedent to back your strategy

To be fully safe in your time period, ask your CPA to look up if any tax court rulings on the subject have come down in your part of the country. If someone in your area of the country has gone to court and won, then using their renting time period provides at least some assurance that the courts in your part of the country have accepted the renting period as adequate.

If you do pursue this strategy, be very careful about getting advice from people who seem to be telling you what you want to hear. The IRS has already threatened they will aggressively pursue people who push the 1031 exchange rules.

Joshua Escalante Troesh is the President of Purposeful Strategic Partners and a tenured professor of Business at El Camino College. To explore working with him on your personal financial planning and investment advising needs, simply schedule a free Discover Meeting.

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