Being strategic about financial planning when selling, gifting (or bequeathing) real estate can help you clarify your sales goals and timing, create new buying options, and possibly reduce tax implications. This article involves looking at real estate transactions from a different perspective than you might normally, while considering a wider range of benefits or potential drawbacks. The right opportunities for you will depend on several factors, including the type and value of the property, as well as your investment amount.
Below are seven planning strategies for a real estate sale in the U.S. — both personal and business — to consider before the transaction, which can benefit your financial plan afterward.
1. The 2-out-of-5-year rule: The sale of your primary residence can have potential capital gains tax reductions (which are different from selling business, rental or investment properties), especially if you have enough time before putting your home on the market.
Tax rates on the sale will be determined by how long you owned and lived in the property, your taxable income, and your marital status. IRS Code Section 121 allows an exclusion of tax on the profits of up to $250,000 for single filers and $500,000 for married couples when selling your primary residence, if certain conditions are met.1 One of those conditions is maintaining residence in the house for at least two years, which are not required to be consecutive, out of a five-year period before selling it. For instance, you could live in the house for one year, rent it out, then move back in for a year before the sale. This requirement, also known as the 2-out-of-5-year rule, can be fulfilled by only one spouse of a married couple living in the home. Another important aspect is how the home is deeded. Special rules of Section 121 include allowance of the exclusion every two years, as well as partial exclusions for cause, such as military, job-related moves, or other circumstances.
2. Rental property income and tax benefits: Before selling your primary residence, you might consider renting out the home for extra cash flow. The average annual revenue for all sole proprietorship Airbnb businesses in the U.S. was $29,183, according to a March 2023 analysis.2 On the other hand, if you plan on selling a home that was first rented out, you may want to consider converting it to a primary residence and taking advantage of the 2-out-of-5-year rule. Keep in mind that during the time the property was rented it doesn’t qualify as residential and won’t be eligible for the capital gains tax exclusion.
Rental property depreciation allows you a tax deduction each year to help cover the cost of buying and improving the property. Though cost attributable to land is not depreciable, IRS allows depreciation over a 27.5-year period for residential and over 40 years for commercial properties starting with the date they are available for rent.3
3. Basis step up rule: If your will leaves real estate to a loved one as part of your estate plan, you can reduce the amount of taxes owed by the heir, per IRS Section 1014.4 The step-up in basis rule allows the recipient to pay taxes on the home’s market value upon your death. This reduces the capital gains tax that would have been applied to the appreciation of the home’s value after you purchased it. For example, if you bought property long ago for $100,000 and the market value has increased to $550,000 at the time of your death, and your heir then sells the home for $600,000, the taxable capital gain would be $50,000 instead of $500,000. The lower capital gains tax rate would apply to a considerably reduced amount on account of the basis step up. NOTE: Inheritance of property creates automatic long-term tax treatment, even if the property was short-term to the decedent.
4. Gifting rules: In comparison to special rules applied to inherited property, as described above, the landscape is quite different when property is gifted. When gifting is used to transfer property to someone during your lifetime, the excess of the fair market value over the annual gift exclusion amount would use some of your unified gift and estate tax exemption.
The recipient would receive a transferred holding period (length of time held you held before selling) and basis (value of the home for tax purposes) from you upon receipt. Let’s reconsider the example above in the basis step up rule and compare it to the rules here. With gifting, the taxable capital gain would be $500,000 based on the transferred basis and holding period rule. For more information on estate and gift taxes, view Estate and Gift Tax: Essential Considerations.
5. 1031 exchange: If you have business use or rental property you plan to sell, you might want to consider deferring some or all the capital gains taxes by investing the proceeds from the sale into similar (often called like-kind) property. This provision does not apply to personal use property. Make sure you don’t receive any proceeds directly and that they are held in escrow until replacement property is acquired. Also known as a like-kind exchange, IRS Section 131 allows you to take advantage of postponing paying capital gains taxes on this and future exchanges.5 The tax code is specific about qualifications for the exchange, such as time limits, so it’s best to consult with qualified tax professionals before the transaction occurs.
What’s interesting here is that like-kind is a very broad concept, meaning you can exchange a single rental home for a plot of land, a car wash, a commercial building, or any type of business use or rental property. There are strict 2-year time limits both before and after the exchange that prohibit personal use. Your basis in your sold property becomes the basis of the new property.
6. QOZ’s (Qualified Opportunity Zones): Another tax deferral strategy involves QOZ investments, which defer federal capital gains from personal use or business property for reinvestments made within 180 days to a QOZ funds. The deferral is reported as a capital loss in the year of investment and will reappear on your 2026 return in the same amount.
Though the deferral from capital gains is short, the best part of a QOZ strategy is the potential for full tax-free growth in the QOZ fund if a 10-year holding period is met after the time of initial investment.
Another important consideration is that three states — California, Mississippi and North Carolina — do not conform to the federal QOZ rules, while two others — Arkansas and Hawaii — only conform for QOZ investments in those states. Lastly, Massachusetts only conforms for business entities, not individuals.
7. Installment sale: When you decide to sell an eligible property and the sales contract involves receiving payments from the buyer after the year of sale, this is considered a structured installment sale under IRS Section 453.6 The tax rule allows the capital gains you would owe on payments and interest to be spread out over the scheduled time duration of the loan. Factors to consider with this type of transaction include interest rates, potential changes in tax code that could increase the capital gains rate, as well as the Net Investment Income Tax (NIIT) of 3.8% on certain amounts of investment income.
The default provisions of installment sales apply for all qualified transactions where proceeds from the sale extend past the year of sale. Each taxpayer is allowed to elect-out of these provisions if so desired.
Bottom line
While there are many ways to reduce taxes owed on the sale of real estate by legally taking advantage of the opportunities for financial planning, the rules are often complex and difficult to navigate without the help of knowledgeable and experienced tax professionals. Because each transaction can have a unique financial impact, understanding your options and how it will affect your tax and long-term goals are crucial.
If you are a client of Mercer Advisors, consult with your wealth advisor who can work with tax and legal subject matter expert team members who specialize in tax planning to help strategize the right options for you when selling real estate.
If you are not a Mercer Advisors client and want to know more about the benefits of financial, legal and tax planning strategies, let’s talk.
1. “Capital Gains Tax Exclusion for Homeowners: What to Know,” Kiplinger, May 5, 2024.
2. “11 Airbnb Industry Financial Statistics: Sales, Expenses, Profit and More,” ProjectionHub, March 13, 2023.
3. “How to Calculate Rental Property Depreciation,” Investopedia, Nov. 27, 2023.
4. “What is a step-up in cost basis and how can it affect me?,” Fidelity, May 14, 2024.
5. “Capital gains tax on real estate and selling your home,” Bankrate, March 15, 2024.
6. “An Introduction to Structured Installment Sales,” CPA Journal, Dec. 2021.
Mercer Advisors Inc. is a parent company of Mercer Global Advisors Inc. and is not involved with investment services. Mercer Global Advisors Inc. (“Mercer Advisors”) is registered as an investment advisor with the SEC. The firm only transacts business in states where it is properly registered or is excluded or exempted from registration requirements.
All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. Some of the research and ratings shown in this presentation come from third parties that are not affiliated with Mercer Advisors. The information is believed to be accurate but is not guaranteed or warranted by Mercer Advisors. Content, research, tools and stock or option symbols are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. The hypothetical example above is for illustrative purposes For financial planning advice specific to your circumstances, talk to a qualified professional at Mercer Advisors.
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