How Capital Gains Taxes are Hurting More and More Homeowners

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Recently, a fascinating discussion unfolded on the BiggerPockets forum. It concerns capital gains taxes and how homeowners who stay in their quickly appreciating homes are hit hard when it comes time to sell—even factoring in the capital gains tax relief the IRS offers for single and married couples selling their primary residences that have appreciated by $250,000 and $500,000, respectively.

In short, as the forum poster, Brian J. Allen, astutely concluded, a homeowner who moves every few years to a more expensive home as their home appreciates would be left with a much smaller capital gains tax hit when they eventually decide to downsize than an owner who stayed in their home. He also made a fair point: Increasing the limits of capital gains tax relief was long overdue, as the current ones were set in 1997, and the limits have not kept pace with inflation.

8% of Homes Sold in 2023 Exceeded the Capital Gains Limit

According to CoreLogic, a property analytics company, as prices have risen sharply around the country, the amount of capital games taxes homeowners have had to pay when they sell has been a growing issue. Almost 8% of homes sold in 2023 exceeded the capital gains limit of $500,000 in appreciation. 

For some perspective, according to CoreLogic:

“Between 2000 and 2003, a few years after the passage of The Taxpayer Relief Act of 1997, only about 38,000 home sales per year, or 1.3% of existing home sales, had gross capital gains that exceeded the exemption limit.” 

However, this has changed dramatically since then:

“In the peak year of 2022, more than 300,000 home sales had gross capital gains above the $500,000 exemption limit, a staggering 140% increase from pre-pandemic levels….At the end of 2023, home sales that required capital gains payments stood at 7.9%,150% higher than the 2017-2019 average.”

Homeowners in rapidly appreciating areas like New York, New Jersey, Florida, Colorado, Massachusetts, and California have been the hardest hit. These states combined saw a total of 68% of national sales that had gross capital gains above the exemption limit between 2017 and 2024.

A Holistic Approach

Homeowners selling homes with a lot of equity are in a difficult situation. Solutions to capital gains exposure require looking at the problem holistically by determining each owner’s comfort level and long-term intentions. No one enjoys paying taxes if they don’t have to. There are workarounds, but none are as simple as just selling your home and being done with it. 

Here are some solutions if you are open to the idea of using investing as a strategy to offset/defer taxes.

Move out, rent your primary residence, and 1031 exchange it

Moving out of your primary residence, turning it into a rental, and then doing a 1031 exchange on the property when you sell it would defer your capital gains taxes to your next investment. The good news is that if you hate the idea of dealing with tenants and being a landlord, your next investment can be more passive—you become an LP in a syndication, where you do not deal with the management side of things. Other vehicles include industrial buildings, storage units, or any real property being used for business or investment purposes.

To pay for your new, downsized primary residence, you could either get a HELOC, which the cash flow from the new investment would pay for, or take some money out of the 1031 exchange when you sell, pay taxes on it, and buy your new primary residence for cash. 

Hold the note

Being the bank is a great way to minimize your tax exposure because you do not receive a lump sum of cash from the sale of your property if you hold the note and allow a homeowner to make payments over time. The fractional portion of the gain will result in lower taxes than that on a lump-sum return of gain. How long the property owner holds the property will determine how it’s taxed: as long-term or short-term capital gains.

Put your primary residence into an irrevocable trust and pass it to your heirs

If you intend to pass on assets to your heirs after you die, your kids will do much better financially if your assets were placed in an irrevocable trust, of which they were the beneficiaries, than if you simply sold the asset, paid taxes, and passed on the proceeds.

According to Investopedia.com:

“If you inherit a home, the cost basis is the fair market value (FMV) of the property when the original owner died. For example, say you are bequeathed a house for which the original owner paid $50,000. The home was valued at $400,000 at the time of the original owner’s death. Six months later, you sell the home for $500,000. The taxable gain is $100,000 ($500,000 sales price – $400,000 cost basis).”

Things get more interesting when trusts are introduced, specifically irrevocable trusts. Here’s how they work, according to SmartAsset.com:

“Assets in an irrevocable trust do not contribute to the overall value of your estate, which, for a particularly large estate, can shield those assets from potential estate taxes. But that doesn’t mean the assets in an irrevocable trust are shielded from taxes altogether. Instead, the assets in an irrevocable trust are taxed at different rates depending on their status. In most cases, this means either the trust itself pays income tax on undistributed gains, or a trust’s beneficiary pays income taxes on money they receive from that trust.”

There are many different types of trusts, and a discussion with an asset manager can help you decide which kind of trust is right for you. The downside of a trust is that you—the homeowner—no longer control the property; the trust does. But if you’re sure you want your heirs to get as much of your assets as possible, they can be a great vehicle for minimizing tax exposure. 

Final Thoughts

The quality of life aspect is often overlooked in real estate investing discussions. For older homeowners, ensuring that they are minimizing stress for their remaining years often supersedes maximizing the amount of money they can make in the future—because at a certain age, your future is not guaranteed.

Investing in real estate, dealing with tenants, and incurring debt do not always increase the quality of your life as you age. In fact, it could minimize it. If you are financially comfortable, the advantages of paying Uncle Sam his due so you can get on and live an unencumbered life, travel, and enjoy quality time with your family cannot be overlooked, even if, on paper, it does not make the most financial sense.

Alternatively, discussing ways to transfer your real estate assets into completely passive forms of investment while minimizing your tax exposure is something to chew over with an asset allocation professional.

I’ve tried to interest my kids in real estate investing (I have two college-age daughters). I’ve driven them past my rentals and told them, “It’s time to get acquainted with the family business!” doing my best Marlon Brando/Don Corleone impression. They’ve momentarily looked up from their phones, registered complete disinterest, and gone back to scrolling. 

I hope they can come around so that when the time comes that I no longer want to be bothered with the stress of being a landlord, they can take the reins. It’s a nice thought, but I’m not counting on it.