Navigating Home Sales, Investing, 1031 Exchange and More

Oct 4

Tips for Wise Real Estate Investing

Do you like to use real estate as part of your financial plan and investment strategy? Are you considering selling your home then waiting a couple of years before buying another one?

This can raise several financial questions and concerns to prepare for – How do you mitigate tax implications? How do you manage the proceeds of the sale effectively?

Let's explore these questions through a real-world example — a homeowner planning to sell his primary residence and buy a new property in a few years.

Disclaimer: This blog post is for informational purposes only and does not constitute tax or financial planning advice. The author is not a CPA or Financial Advisor. It is essential to consult qualified professionals for personalized guidance before making any real estate, tax, or investment decisions. The information provided may not be up to date, and the author and publisher are not liable for any financial decisions made based on this content. Readers should stay informed about changing regulations and seek professional advice for their specific situations.

Step 1: Assess the Tax Implications

Before making any moves, it's essential to assess the tax implications of selling your property. Taxes can take a considerable chunk out of your profits if not planned for correctly. Your situation might benefit from a 1031 exchange or an exclusion.

What is a 1031 exchange?

According to Investopedia, “A 1031 exchange is a swap of one real estate investment property for another that allows capital gains taxes to be deferred.” In other words, a 1031 exchange allows you to reinvest the proceeds from the sold property into a like-kind property, deferring all capital gain taxes.

An exclusion means that you are excused from paying taxes.

Being informed and intentional about tax implications with your home sale decisions is critical. You do not want to skip this step. Check with your tax professional to determine the most tax-advantageous maneuver prior to listing the property.

Case-Study: A Tax-Free Situation

Our homeowner is married and planning to make between $200,000 and $300,000 on the sale of his primary residence. In this case, he doesn’t have to worry about capital gains tax. According to IRS code, a married couple filing jointly can exclude up to $500,000 in capital gains on the sale of their primary home, provided they've lived there for at least two of the last five years. So he will walk away with all of the money in his pocket and none of the proceeds going to Uncle Sam.

Step 2: Strategizing Post-Sale Proceeds

Once you've navigated the maze of tax implications, the next question is:

Where should the money go?

If you’re only waiting a couple of years before purchasing another property, this money should ideally be placed where it can earn some interest without a high risk of principal loss. This is important because of market volatility. If you invest your sale proceeds into a highly volatile investment like single stocks, you might find yourself with less money when it comes time to purchase your next home. Versus, if you have a longer-term time horizon, you can mitigate the risk of losing money as the stock market tends to go up over time.

But for a window of time less than five years, I would recommend you put the money in an investment vehicle that has a very low likelihood of principle erosion, such as a money market, certificate of deposit (CD), or maybe even just a checking account. Of course, you want the money earning you money, rather than rotting away in a checking account, but in the short term, while waiting to invest the money into a new home, protecting the principle is the most important goal – not earning investment returns.

Certificates of Deposit: A Low-Risk Option

For short-term financial goals, a Certificate of Deposit (CD) at a bank can be a robust option.

These financial instruments are about as close as you can get to a principal guarantee while still earning some interest. Currently, some CDs are offering an interest rate of around 5%, a return not to be scoffed at, especially considering the low risk involved. Inflation is currently running around 3.7%, so with a 5% return on a certificate of deposit, your money is keeping up with inflation without a big risk of principal loss. That’s EXACTLY what you are trying to accomplish in a short-term situation such as this.

Weighing the Risks

Investments and financial strategies come with risks, and while CDs are a low-risk option, they're not entirely risk-free. It's crucial to understand your comfort level with risk and adjust your strategies accordingly. For example, in a CD, you are generally required to keep the money in the account for a pre-determined period of time. Term lengths range from five months to five years, but typically, your money will be tied up for 6-12 months. So, a risk to consider is if your timeline changes or you discover a MUST-HAVE property, then you may have to pay a penalty to access your money if the account has not matured.

Selling your home and planning for a future property purchase involves several moving parts, from tax considerations to investment strategies. The best practices you want to consider are to (1) outline a path to reduce or eliminate taxes and (2) mitigate investment risk while providing a modest return on your investment proceeds so the value of your money keeps up with inflation with minimal risk of principal erosion.

By doing your due diligence and considering these options, you can navigate the complex waters of real estate and investments effectively.

Rooting for you!

Brent Edwards (aka Brent the Broker) is a residential real estate agent and Realtor in San Diego, CA who helps clients buy and sell homes in San Diego, California and all surrounding areas. Brent is a highly-recommended Realtor in San Diego by family, friends and past clients. Call Brent today at 619-550-8070 if you have any questions about real estate in San Diego or you'd like to buy or sell a home.