Do I Have to Pay Capital Gain Taxes If I Sell a Rental & Invest in a Principal Residence?

How you sell or exchange your rental property determines if you have a taxable capital gain.

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Selling a rental property and buying a home may seem like the same thing. The properties are both real estate and the transactions must be conducted in accordance with existing real estate laws. However, for taxation purposes, the IRS considers rental property and a personal residence in separate classes. This distinction determines whether you have a taxable capital gain at the end of the transaction.

IRS Capital Assets

Under IRS definition, a capital asset is any asset that is purchased or sold for investment or personal use. If you bought the rental as a source of rental income, the investment is considered a capital asset. The rental’s purchase price along with the transaction’s closing costs is the property’s tax basis. Any permanent improvement you make that increases the property’s value or prolongs its useful life increases your tax basis. If you sell or exchange the rental, any gain will be taxed at the capital gains rate.

Section 1031 Like-Kind Exchange

To defer the capital gains tax, the IRS allows you to exchange one capital asset for another if it is the same type of capital asset. You can exchange the rental property for a similar rental property or sell the rental and purchase a similar one within 180 days of selling the first rental. Under IRS Code Section 1031, you must use the second rental property for the same purpose as the original rental. If you exchange the rental property for any other type of property such as a personal residence, the transaction will not qualify under Section 1031 rules.

Calculating a Capital Gain

If you sell your rental property and buy a residence for your personal use, you must report any gain to the IRS. You can calculate your gain by subtracting your basis in the rental property from the gross sale proceeds. For example, if your rental basis is $150,000 and the gross selling price is $200,000, your capital gain is $50,000. You must include the fair market value of any services you received as part of the sale proceeds. You cannot exclude or defer the $50,000 gain you made on the sale.

Reporting Your Gain

Report your gain from the sale of the rental property on your personal income tax return. Use Schedule D to report the transaction and attach it to your Form 1040 before mailing it to the IRS. If you lost money on the sale, you can use the loss to offset any capital gains for that year. Your unused capital losses can be carried forward and used on future tax returns.