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Sell A House Before 2 Years
After purchasing a property, you can do whatever you want with it. Yes, you can even sell your home as soon as you got it, but it is generally smart to hold onto it for at least 2 years before selling to avoid a heavy tax penalty.
According to the National Association of Realtors (NAR), the average homeownership tenure in the United States is 13 years, and this is for good reason. But what if you absolutely need to sell your home early on, say before the 2 years is up?
For instance, you need to relocate because of your job, you are under financial stress because of a health emergency, or you need to move out of state because of a change in the family situation-- what can you do, then?
If you really are pressed for time and must absolutely sell now, we gathered the best ways to help you sell your house before 2 years while softening the tax burden.
Do You Have to Pay Capital Gains Taxes If You Sell Your Home Before 2 Years?
Capital Gains on Your Property
In the best case, your property may have appreciated in value in the year or so that you have lived in it. This means you may be able to sell for a profit known as capital gains.
You may not be able to pocket all of the gains though, since the profits would be subject to capital gains tax. Capital gains form part of your taxable income, and the Internal Revenue Service (IRS) would want a piece of that pie!
The amount of capital gains taxes you need to pay depends on the increase in your home's value, your income tax rate and your length of home ownership prior to selling it.
Short Term Capital Gains
If you're selling your home within 1 year of owning it, this will be classified as short term capital gains. You will need to pay taxes of up to 37% on the profits, depending on your tax bracket.
Long Term Capital Gains
If you're selling a house after 1 year of owning it but before the 2 years is up, this will be classified as long term capital gains, you will need to pay capital gains tax for an average of 15% on the profits.
Exception to Capital Gains Taxes
The tax shield becomes available when selling your home after living in it for 2 years.
This is found in Section 121 of the tax code, also known as homeowner exclusion. It entitles you to not pay capital gains tax on up to $250,000 of the profits if filing as a single individual; and an exemption on up to $500,000 of the profits for married couples filing jointly.
However, you can still protect your profits as long as you have lived in your home for some time for capital gain. For example, if you lived in it for one year, you can claim a 50% tax shield. This means, profits of up to $125,000 and $250,000 if filing as a single individual or as a married couple, respectively, is protected.
If you lived there for more than a year, you can claim a higher tax shield percentage. The long term capital gains tax rate will apply instead of the short term capital gains tax rate.
What are the Exceptions to the 2 out of 5 Year Rule?
The 2 out of 5 Year Rule in Real Estate
For a property to be considered your primary residence, and thus, eligible for the maximum amount of tax shield mentioned above, you must live in it for two years in the five years of owning it.
Therefore, if you own more than one investment property, it is typically a good idea to live in it for at least two years. You can then have two primary residences, as the two year requirement need not be continuous.
This is known as the 2-out-of-5-year rule in real estate.
However, there are exceptions to this requirement, and it is still possible to qualify for maximum exclusion of capital gains if the following is applicable to you:
- You or your spouse is a service member (military, peace corps, police) during your tenure of the home.
- You converted your home, or a portion of it, into a commercial or rental property.
- You bought the home and are selling it in a like-kind, or 1031 exchange (read more below).
Are There Ways to Avoid Capital Gains Tax when Selling a House Before Two Years?
While you may not be able to totally avoid capital gains taxes when selling a house before two years, you can minimize the tax penalty for selling by exploring the following:
Cost Basis Adjustments
Tax penalties can be reduced by raising your cost basis.
This means that if you bought your home, say a year earlier, for a purchase price of $100,000, and you are now selling it for $160,000, capital gains taxes will apply on the $60,000 difference.
However, you have made improvements such as an additional patio, a central air conditioning system, and new exterior sidings totaling $25,000, and you have kept all the receipts...
This cost of home improvements would raise your cost basis and be deducted from the $60,000. Therefore, the capital gains tax you need to pay will be reduced as it only applies on the $35,000 remaining.
Partial Capital Gains Tax Exemptions Per IRS Guidelines
You can also check if you qualify for a partial exemption on capital gains. The Internal Revenue Service (IRS) grants these partial exemptions if you need to sell your home due to the following reasons:
The IRS gives consideration if you, your spouse, or your co-owner is forced to move to a new job location that is at least 50 miles away from your home. You have a choice to either rent out the property, or sell it to afford the down payment for a new property much closer to your new workplace.
If this happens, you qualify for a partial exemption from paying capital gains taxes if you do decide to sell your house.
You can avoid paying taxes on your profits after a home sale if it happens because of a health-related reason. It could be that you are prescribed by your doctor to move somewhere else, say, a warmer climate; it can also be that you may need to seek treatment for yourself or your family member in another state or country; or, an ailing family member needs to be taken care of long term, and it would entail selling your house and moving in with them.
Other unforeseeable events
You can have a reduced tax penalty for selling before two years have passed if you are forced to do so due to the following:
- Natural disasters such as floods, earthquakes, hurricanes, storms, and so on
- Man-made disasters
- Act of terrorism
- Unforeseen life events such as a divorce, a death in the family, or loss of a job that would drastically reduce your household income and render you incapable of paying your living expenses and real estate taxes, and thus, make you eligible for unemployment compensation
- Other events that may be deemed unforeseeable by the IRS
You may need to get in touch with an accountant in order to determine how much exemption you qualify for before selling your house.
Take Advantage of the 1031 Exchange on Investment Properties
If this can be considered an investment property, then you can take a page from the playbook of real estate investors and house flippers, and use a tax break known as a 1031 exchange.
House flippers typically own the property for less than a year before finding a buyer, so they can't avoid capital gains taxes right?
The answer is no. They sure have a few tricks to help them avoid paying tax penalties.
Taken from Section 1031 of the Internal Revenue Code, you can use this to defer paying capital gains taxes. You can do this even if you are selling a home before two years as long as you will be using the proceeds to acquire another investment property. In order to take advantage of this, you must close within 180 days on the new property.
You must remember though, that selling your primary residence does not qualify you for a 1031 exchange.
How Long Should You Live in a House Before Selling It?
When you acquire a house, particularly if it is under a mortgage loan, it could take a while to build equity. Equity is the difference between how much you owe on your mortgage and how much your home is actually worth.
Therefore, as long as you make your monthly payments, your equity will increase. However, it is also important to know that at the start of the installment contract, a large part of the payments you're making goes to interest. So, if you sell very early on, you might actually end up losing money.
You Must Be Able to Build Enough Equity
If you sell your home with a real estate agent, the real estate agent fees alone average 6%. This could eat up what little equity you have built up. Not to mention closing costs. If you do not have enough equity, you may not be able to afford the down payment on a new place.
A worst case scenario is if your home depreciates during the course of ownership, resulting in capital losses. This could mean your selling price might be below your purchase price!
Consider Renting Out the Property First
If you need to move elsewhere, you can consider renting the property out until the two years is up.
The proceeds from the rental can be used to pay your mortgage and allow you to continue building equity. However, the rent is considered part of your ordinary income, so income tax rates would apply.
Waiting two years before selling a house also significantly reduces your tax burden and would allow the property to appreciate so that the increase in value can take care of whatever tax penalties may remain.
Final thoughts: Selling a House Before Two Years
Real estate has long been considered a sound investment. Despite a few setbacks in the last two decades, it has repeatedly shown that it can bounce back over time, and as of now, real estate prices are climbing steadily.
Therefore in order to maximize the appreciation of your asset, avoid paying capital gains taxes, and sell your house for top dollar, it is generally advisable to do so after two years.
However, it has been shown that not everyone can have the luxury of time...
And while there can be a hefty tax penalty for selling before two years, there are ways to legally sell your home, avoid capital gains taxes, and still walk away with a tidy profit.
Here at Sell My House Fast, we'll help you to literally do just that!
We eliminate the hassles and drawbacks of working with real estate agents. Plus, we cover all closing costs, so what we offer is what you actually get at closing.
After filling out the form below, we'll connect you to our active pool of local cash buyers. As local buyers, we're familiar with the market conditions, so we can make you a fair cash offer!
If you'd like help in selling your home, get in touch with us at (844) 207-0788 and we'd absolutely love to hear from you!