By David Morton

Selling a home is commonly a stressful time. You prep the property to attract ideal buyers, line up competent movers, and keep your fingers crossed that the buyer’s inspector doesn’t craft a punch list chock-full of issues ranging from the ticky-tacky to major deal-breakers.

But assuming you’ve crossed that ever-important “closing” date finish line and the funds have hit your account—ah, exhale—what sort of smart options do you have for the money?

Of course, you still need a place to live, so for the sake of this discussion, let’s consider two scenarios: (1) You’re downsizing to a smaller home that requires less capital, and/or (2) You sold an investment property such as a second home, rental house, or condo.

Primary Residence

First, let’s understand some basic tax parameters. For a primary residence, you can keep tax-free up to $500,000 of realized gain— basically the difference in what you paid for the home vs. what you sold it for—for married couples or $250,000 for single tax filers.

So if you and your spouse bought your home for $500,000 more than two years ago, then you could sell your home for up to $1 million and book the $500,000 gain tax-free.

Anything above the $1 million sales price in this example (i.e., more than a $500,000 gain) would likely be subject to a 15% or 20% federal long-term capital gains tax bite, depending on your income level. Generally speaking, under current tax law, you would pay the higher 20% rate if you had an income of $488,851 for married folks filing jointly, or $434,551 as a single filer.

Keep in mind that you would have needed to own the house for two years and lived in it as your primary residence for a combined 24 of the past 60 months to qualify for this fairly generous tax exemption.

This hypothetical also assumes that you didn’t make significant capital improvements that you could add to the cost basis. For example, if you spent $100,000 on finishing a basement, you could add that to your cost basis of $500,000, thus making your gains on up to a $1.1 million sale ($500,000 gain on top of the now $600,000 cost basis) tax-free to married couples. Just remember to keep your receipts for all improvements made to the property.

Investment Property

In the second scenario, if you sold an investment property (typically rental properties), the tax maneuvering would be different. If you booked a $200,000 gain, you could pay the state and federal tax on the entire gain at the applicable rates. However, if you wanted to defer all taxes, you could do what’s called a "1031 exchange," which is effective in kicking the tax liability down the road but also has strict rules that need to be carefully adhered to.

The biggest challenge under this 1031 framework is working within some very tightly defined time windows once the old property is sold. First, you have 45 days to identify in writing the new investment property or properties to be purchased, and next, any gains on which you would like deferred tax treatment would need to be invested in that property, of equal or more value, within 180 days.

This is quite a short runway to navigate. If you go this route, make sure you have things lined up for both transactions to close within the narrow time window, under the supervision of an IRS-mandated independent third-party Qualified Intermediary, or QI. Otherwise, you would be liable for any long-term gains tax, which may or may not be super critical depending on your situation or financial position.

Note that 1031 exchanges are complicated and not right for everyone. We could devote an entire white paper to the subject and still not cover all the IRS rules, transaction intricacies, and potential pitfalls. 

You should consult your CPA and/or tax attorney to provide guidance on your situation, including reviewing laws particular to the state(s) in which property is being bought and sold, as well as the issue of depreciation recapture.

What to Do with the Proceeds

Let’s assume you banked some equity and now have a nice cash hoard sitting in your checking or savings account, earning next to nothing in interest. 

First, you absolutely need to clear the deck on any and all “bad” debt such as high-interest credit card balances, then look at other areas such as vehicle loans with unfavorable terms (e.g., loans with interest rates at or above 6%). 

You also should ensure you have an adequate cash reserve in a savings or money market account in case of an emergency. The typical rule of thumb is three months of living expenses, but I feel comfortable recommending two months as long as you have accounts that you can tap without penalty, including brokerage accounts as well as retirement accounts (e.g., 401(k) plans and IRAs) if you are 59.5 or above. 

Speaking of retirement accounts, are you maxing out annual contributions on your tax-advantaged accounts like a 401(k) or even your traditional or Roth IRAs? Let’s say you’re contributing only $1,000 per month to your 401(k), but you can sock away much more (for 2019, you’re allowed to contribute $19,000 per year plus an additional $6,000 if you are 50 or older).

Why not max out to the IRS limit, giving you the one-two punch of setting more aside for retirement while also lowering your taxable income? Work with your firm’s HR rep to change your salary deferral to hit the target by year-end. Any salary that would have been used for everyday expenses can now be taken out of the cash you have from the home sale. 

If you don’t have a work-sponsored plan (e.g., a 401(k), 403(b), or Thrift Savings Plan), then turn to a traditional or Roth IRA and cut a check for $6,000 plus an additional $1,000 if you’re over 50.  

If you can check off all of the above items and still have money left over, take a step back and evaluate where you are in your life (e.g., pre- or post-retirement), what your priorities are, and what your confidence level is toward achieving your goals. 

Whether it’s investing in financial markets, buying property, or taking a look at potential long-term-care needs, work with an independent financial advisor who is a fiduciary—not a salesperson that answers to a corporate entity. This fiduciary advisor, who must legally act in the best interest of the client, can help you clarify your vision and, more importantly, help ensure you’re on the optimal path to balance your near-term needs with your long-term plan.   

Schedule a complimentary consultation with a fiduciary financial advisor to discuss your personal situation.