Federal Income Taxes

Homeowners and investors have options to possibly exclude or defer taxes that are due upon the sale of a property in the following ways.

Section 121 Exemption

Under section 121 (a) and (b) of the Internal Revenue Code, taxpayers who owned and used property as a principal residence for at least two of the previous five years ending on the sale or exchange date can exclude up to $250,000 for an individual or $500,000 for certain joint filers on the gain. During the five years before selling a home, the homeowner must have at least two years of ownership and 2 years of use as a primary residence. The two years do not need to be consecutive, but both the use and the ownership tests must be met. A family unit cannot designate more than one property as a primary residence, even if the properties are held in separate trusts. Taxpayers, including married couples should have only one primary residenceThe main home is always the residence where the taxpayer ordinarily live most of the time. The taxpayer’s primary residence is the address listed on their drivers license or tax documents. A property cannot be a primary residence and a second home at the same time.

Profits from the sale of a primary residence in excess of the exclusion amount will be subject to capital gains tax.

Section 1031 Exchange

IRS Section 1031 provides an exception and allows the taxpayer to postpone paying tax on the capital gain of a sold property if one reinvests the proceeds into a similar like-kind property as part of a qualifying like-kind exchange. Gains deferred in a like-kind exchange under IRS Section 1031 is tax deferred, but it are not tax free. Whenever one sells a business or investment property and has a gain, one generally pays the tax on the gain at the time of the sale. Notice that a 1031 exchange is a deferment, not a credit or reduction. Although taxes do not have to be paid at the time of the sale, they do have to be paid eventually. It is possible for the final investment to convert into the investor’s primary residence, but they will need to hold the investment for no less than five years, or the sale will be fully taxable. Certain properties, such as securities, stocks, bonds, or notes do not qualify for tax deferred exchange.

Proceeds from the sale must be held in escrow by a third-party intermediary, then used to buy the new property. One may not receive the sale proceeds, even temporarily. There is no limit on how frequently one may do a 1031 exchange. This treatment allows an investment to continue to grow tax deferred. One may roll over the gain from one real estate investment to another and another etc. The taxpayer avoids paying tax until they sell for cash years later, and will pay only one tax at the long-term capital gain rate in effect at thet time of the sale.

In a 1031 exchange, once the sale of property occurs, the intermediary (middleman) must receive the cash from the sale. Within 45 days, one must designate the replacement property in writing to the intermediary, specifying the property one wishes to purchase. Up to three properties can be designated, as long as the taxpayer eventually closes on one of the ones identified. Within 180 days after the sale of the old property, one must close on the new property.

Information is always subject to change on this topic. To learn more visit the IRS site.

1099-S Form

The purpose of Form 1099-S is to ensure that sellers are reporting the full amount of their capital gains on each year’s income tax return. The IRS requires that taxpayers report not only their standard income, but also the profit they made on the sale of property. If a title company is used to close on property, the company will file the 1099-S form. It is important that the title company receives all of the information they need to properly file the 1099-S form, such as tax ID’s and social security numbers. Failure to supply this information will not only keep the title company from being able to provide the IRS with correct information about the sale of the property—it could subject the taxpayer to civil or criminal penalties.

The 1099-S amount reported is the gross proceeds of the sale, not ther net proceeds. Gross proceeds include cash received, notes payable to the seller, and any liabilities the seller assumed by the buyer. Gross proceeds don’t include separately stated cash received for personal property.

It should be noted that if the sale relates to a taxpayer’s primary residence, the transaction may not be reportable depending on certain circumstances. Taxpayers should always consult a tax professional.