The $250,000 / $500,000 tax-free home sale profit rule is a fantastic benefit for homeowners who have lived in their homes for two out of the past five years before selling. The rule is also called the tax-free exclusion rule.
The tax-free profit exclusion rule essentially says if you are single, you can earn up to $250,000 in tax-free profits. If you are a married couple, you can earn up to $500,000 as a married couple.
If you are in a top marginal income tax bracket, then the tax-free home sale profit rule becomes even more valuable. For example, imagine if President Biden raises the highest marginal tax rate to 39.6%. To earn $500,000 in profits after tax, you would need to have a gross profit of roughly $833,000!
The tax-free profit rule seems straight forward. However, there may be some confusion. So let’s clarify using an example!
Clarifying The $250,000 / $500,000 Tax-Free Home Sale Profit Rule
In the post, Buy Real Estate For Capital Appreciation, Rental Income, or Lifestyle, I responded to one reader by mentioning potentially moving back into his rental for two years in order to take advantage of the tax-free profit exclusion. I said they would have to then sell within five years after moving back to get the benefit..
Here’s a great response from reader who is a tax lawyer about earning tax-free capital gains after selling a home.
Well, I hate to be the bearer of bad news, but the rule changed a bit starting January 1, 2009. It used to be that the $250,000/$500,000 exclusion applied so long as you lived in the home for any 24 months of the 5 years preceding sale. Now there’s an exception to the exception to the rule in section 121(b)(4). (Note: it’s the second subparagraph (4) under subsection (b)–apparently the legislature mistakenly enacted two sections called (b)(4).)
The IRS chomps away at the $250k/$500k exclusion amount based on a proration of the amount of time that you’ve held the property as a rental since January 1, 2009 (note that it goes back more than 5 years now to look at the use period). The one oddball exception to that (under (b)(4)(c)(ii)) is that if you lived in the home for 2 years during the past 5, and held it out as a rental AFTER you move out, that period is still counted as qualified use.
I mapped this out once about a year ago before selling my residence-turned-rental condo. I determined that it wasn’t worth moving back in to try to recapture a proration of the exclusion amount.
Example. Let’s assume you lived in the house for 2 years starting January 1, 2009. You then converted it to a rental for 2011, 2012, 2013, 2014, 2015. Then you moved back in for 2016 and 2017 and then sold it January 1, 2018. You would have owned it for 9 years total and lived in it for 4. You would be able to exclude 4/9 of $250,000, and that’s it. Better than nothing. But if you’re reaching for the full amount of the capital gains exclusion, it’s not as generous an exclusion as it was before.
Renting Out Your Property Hurts The Tax-Free Home Sale Profit Rule
Bam! I dig the highlighting of section 121 (b)(4)(c)(ii). As you can tell from the above example, as soon as you decide to rent your property out, your tax-free profit exclusion starts getting whittled away.
One might suggest this person live in her place for longer to gain more tax-free benefits. Here’s another example.
Let’s say the person moves back in for 2016, 2017, 2018, 2019, 2020, 2021, 2022, 2023, 2024, 2025, 2026, 2027, 2028, 2029, 2030 and sells in 2031. They would have owned the property for 22 years, and lived in the property for 17 years. Instead of being able to exclude 4/9 of $250,000 ($111,111), they can now exclude 17/22 of $250,000 ($193,181) from the tax man.
The other solution is to never rent out your property, but sell once you want to move. The $250,000 / $500,000 in tax free profits is like making a $357,000 / $714,000 gross return on an investment for someone paying a 30% effective tax rate. That’s some big bucks! Take a look at the chart I put together for how much in gross profits you need to make with other investments at various effective tax rates.
A 1031 Exchange To Defer Capital Gains Tax
Finally, instead of selling a property for a profit, one can simply conduct a 1031 Exchange. A 1031 exchange is where you buy another property with the profits of the previous property sale so there is never a tax event.
There is no tax shelter available for stock profits, except if you reinvest in an Opportunity Zone fund or investment. But there is a powerful tax shelter for real estate owners. A 1031 Exchange is yet another reason why I prefer real estate to stocks.
The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer’s investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a “paper” gain. — 1031.org
Always Calculate The After-Tax Return On Your Investment
As several commenters mentioned in my Passive Income Rankings post, tax considerations is a huge part of returns. Real estate might be second to the bottom of the list, but it’s at the top of the list of money-making assets thanks to depreciation, mortgage interest deduction, the 1031 Exchange, and the $250,000 / $500,000 in tax-free profits upon sale.
The higher your effective tax rate, the more you should love investing in real estate. You should also be maxing out your 401k as well. If tax hikes happen, investing in municipal bonds will also be more attractive.. You might even want to start a lifestyle business one day by launching your own blog.
When it comes to achieving financial freedom, it’s all about generating as much passive income as possible.
Explore real estate crowdsourcing opportunities.
If you don’t have the downpayment to buy a property, don’t want to deal with the hassle of managing real estate, or don’t want to tie up your liquidity in physical real estate, take a look at Fundrise, one of the largest real estate crowdsourcing companies today.
Real estate is a key component of a diversified portfolio. By investing in a diversified eREIT with Fundrise, you can easily gain high-quality commercial real estate exposure across the heartland.
Another fantastic real estate platform is CrowdStreet. If you are an accredited investor, CrowdStreet focuses on individual real estate opportunities in 18-hour cities. 18-hour cities have lower valuations, higher cap rates, and higher growth rates. The spreading out of America is real. Take advantage.
I personally have $810,000 invested in real estate crowdfunding across the heartland.
Shop around for a mortgage.
Check the latest mortgage rates online through Credible. They’ve got one of the largest networks of lenders that compete for your business. Just fill out what you’re looking for and you will receive competitive, no-obligation quotes in minutes. Your goal should be to get as many written offers as possible. Then use the offers as leverage to get the lowest interest rate possible.
This is exactly what I did to lock in a 2.375% 7/1 ARM for my latest refinance. For those looking to purchase property, the same thing is in order. If you’ve found a good deal and plan to own the property for 10+ years, I’d get long real estate.
Post-pandemic, I think the housing market will perform well for years due to the undersupply of housing. However, with mortgage rates rising rapidly due to inflation and the Fed’s rate-hike cycle, demand for real estate should wane. Hence, if you’ve got better use of your proceeds and are running up against the tax-free profit limit, you may want to sell your primary residence.
The only problem is finding where to go. If you are downsizing or relocating to a lower-cost area of the country, then selling your home may be a great idea. That said, the ideal length of time to own real estate is forever.