Selling your home to put a down payment on a new home is a common practice. It makes financial sense for most home sellers because they can get a mortgage with better terms when they have a strong down payment -- usually 20 percent or more. Sellers can also forgo paying income taxes on the equity from their primary home's sale, even when moving out of state.
You do not pay taxes on modest gains from the sale of your home. When selling your primary home in favor of buying another primary residence, you essentially roll the sale proceeds from one property into the next home, via the down payment. The government allows you to exclude up to $250,000 individually from your taxable income and $500,000 as a married couple filing your income taxes jointly. The same exemption applies when using your sale proceeds to buy an out-of-state primary residence. You can even use the money as a down payment on an investment property in another state without paying taxes on the amount.
Avoiding Capital Gains
The IRS taxes you on capital gains, which occur when you profit from the sale of a house used as an investment property or a second home. The gain is the difference between what you paid for the place, including closing costs, and the amount you sell it for, including selling costs and improvements to the property. You can limit or eliminate capital gains taxes by swapping investment property in what is known as a "1031 exchange." In essence, you can defer paying taxes on the gains from a sale of the home by putting the money down on another investment property, even if the property is in another state.
To qualify for a tax exemption, you have to use the home you sell as your primary residence for at least two of the five years preceding the sale date This means you could have used the home as an investment or rental at one point before selling, then converted it into your primary dwelling to qualify for the exclusion. You do not need to live in the home for two consecutive years or right before selling the home, either, in order to meet the IRS ownership test.
Although you can avoid paying income taxes on the sale of your home and the purchase of another home in a different state, you are still on the hook for property taxes on both transactions. You pay property taxes, if any are due, at closing on your home sale. You also have to pay property taxes on the out-of-state purchase, beginning on the date you take ownership, or your settlement date. In most cases, settlement dates fall somewhere in between the tax period. If you pre-paid your tax bill, the buyer of your home will owe you money at closing to cover the time period after he takes ownership. Likewise, if your seller pre-paid taxes, you owe him money at closing.
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