Capital Gains Rollover: Tax Strategies Explained

deferred gain on sale of home

If you make some wise investment decisions (or have just been lucky), you’ll face having to report capital gains and wondering, “what are capital gains.” While capital gains are welcome, surprise is the feeling many people have when they realize the amount of taxes due on a capital gain. So we’ll look at common strategies to minimize or defer those taxes.

What exactly are Capital Gains?

Capital gains refer to the profit made from an asset’s sale. The asset can be anything from a piece of property to a stock or bond. Capital gains are realized when the asset sells for more than the original purchase price. Conversely, if an asset sells for less than the original purchase price, it creates a capital loss.

Examples of Capital Gains Taxable Assets

Several common assets create capital gains. 

  • Stocks. Stocks include widely traded market shares and privately held shares in small businesses. 
  • Bonds. Bonds trade on the open market just like stocks.
  • Real estate. The sale of real estate can create a capital gain, whether the property is held for personal use or as an investment (although different rules apply to the calculation of the gain depending on the property’s use).
  • Gold, silver, and other metals. Investors often use precious metals as an investment since they often appreciate over time. Purchasing precious metals through a marketplace or held as a physical asset can count as a capital gain when their value increases.
  • Coin and stamp collections. The sale of a collectible at a gain (even if used for personal enjoyment) is a capital gain.
capital gains tax explained

What is Long-Term Capital Gain Tax?

Capital gains created by selling an asset and being held for a year or more are considered long-term capital gains. Long-term capital gains are preferable to short-term ones because they receive favorable tax treatment. The capital gains rate will be between 0-22%, depending on your overall income. Compare that to income tax rates of up to 37% on ordinary income.

What Is Short-Term Capital Gains Tax?

Sell assets you’ve had for a year to achieve short-term capital gains. Short-term capital gains are taxed at higher rates than long-term capital gains. The tax rate is the same as the taxpayer’s ordinary income, which can be up to 15% more than the long-term capital gains rate.

What is a Capital Gains Rollover?

A capital gain is considered income when you prepare your taxes unless you can roll over your gain into a different investment. For example, if you purchase a new asset with a capital gain, that is a rollover. Unfortunately, not all capital gains are eligible for tax-free rollovers into other assets.

Though the option no longer exists, the capital gains rollover was used in the past by homeowners who could defer the capital gain on the sale of their house if they bought another house of equal or greater value within two years of selling their home. The capital gains rollover option ended on May 6, 1997. The more straightforward rule, which allows homeowners to exclude $250,000 of gains from the sale of their primary residence ($500,000 if married), replaced the capital gain rollover.

Other assets, such as vehicles, also used to be eligible for capital gains rollovers, although that option has also ended. 

How to Qualify for a Capital Gains Tax Rollover

Currently, the only assets eligible for capital gains tax rollovers are business or investment real estate or capital gains rolled into an Opportunity Zone Fund (which we’ll discuss below). You cannot roll over capital gains for any personal assets.

What is a 1031 Exchange?

1031 rollover exchange is the rollover of capital gains from an investment property into another investment property. It would be best if you kept in mind that a 1031 does not allow you to avoid paying taxes; it merely defers the taxes until you sell the replacement property (unless you do another 1031 exchange when you sell the replacement property).

Before the Tax Cuts and Jobs Act (TCJA), many businesses would use a 1031 exchange. However, the TCJA restricted 1031 exchanges to real estate. 

If you are selling a real estate investment property and want to purchase another, there are a few downsides to participating in an exchange. The two most significant issues with a 1031 exchange are the quick timeline for finding and purchasing a replacement property and that any cash you take from the sale will be taxable and not eligible for deferred taxation.

To initiate a 1031 exchange, you must declare your intention to do so before selling your investment property. You will need to pay a 1031 coordinator to hold the funds from the sale for you. This is because it’s taxable once you touch the money. There is usually a fee of a few thousand dollars. You must identify a replacement property within 45 days of selling your property, and then you must close on the new property within 180 days. It’s generally best to have a replacement property in mind before selling your initial investment because of the tight timelines involved.

More Capital Gains Rollover Strategies

You can also save money with these alternative capital gains tax strategies. 

Invest in Opportunity Zones

An Opportunity Zone is a low-income area identified by the federal government. The government created these zones to incentivize investors to improve these areas. 

Capital gains from the sale of stocks or real estate can transfer into an Opportunity Zone investment fund without paying taxes on the capital gains. However, you must use the funds in the Opportunity Zone to invest in a property within an opportunity zone. The timeframe for making the new investment is 180 days. 

The main disadvantage of these funds is the restrictions on where you can make your investments. For example, you may not be able to find an attractive investment in an opportunity zone within 180 days.

Section 1202 Exclusions 

Section 1202 exclusions allow you to exclude some or all of the gain from a small business stock sale. The exclusion encourages people to invest in small businesses. 

The rules have changed over the years. The amount of gain you can exclude from your taxable income will vary depending on when you purchased the stock and if you held the stock for at least five years. For example, stocks purchased from February 18, 2009, through September 27, 2010, were eligible for either a 50% or 75% exclusion, and stocks purchased after that date were eligible for a 100% exclusion. Note that this capital gain exclusion only applies to federal taxes and may not apply to state taxes.  

Inclusion means the small business must be worth less than $50 million and not be in specific industries.

Final Thoughts on Capital Gains Rollover

Deferring capital gains allows your investment to continue to grow by deferring the taxes on your profits. Instead, invest the funds meant for taxes in another property. It’s important to carefully follow rollover rules because missing a deadline or improperly handling the funds can make your capital gains taxable. If you need help navigating a 1031 exchange or other capital gain deferment, the tax professionals at Shared Economy Tax can help walk you through the process.