There’s nothing wrong with using profits to pay down debt. That simple transaction reduces leverage. But is it possible to pay down debt using capital gains, and are there any tax advantages to this tactic?
Capital Gains On Primary Residence
Selling a primary residence comes with special tax treatment. This is called the Section 121 exclusion or primary residence tax exclusion. If you have lived at least 2 of the past 5 years in your primary home, gains on the sale are not taxed.
Section 121 allows up to $250,000 in gains for single filers ($500,000 for married couples filing taxes jointly) to be excluded from taxation.
These gains can be used to pay off debt or for any other use. The use of the excluded gains will not affect the tax status of those gains. Once the home sale has been made, the transaction is complete, and so is the Section 121 exclusion. Using gains from the sale is a completely separate transaction.
Using Capital Gains To Pay Off Debt
Without the Section 121 exclusion, are there any other methods for real estate gains to avoid taxation while paying off debt? Unfortunately, no. Gains from the sale of a rental property will be taxed at short or long-term capital gains rates depending on the holding period.
Of course, an investor can always do a 1031 exchange and defer taxes on their property's gains. However, funds will be tied up in the replacement property and unavailable to pay off debt.
If money is leftover (i.e., boot) from a 1031 exchange, it will generally be taxed at capital gains rates. From there, the funds can be used for any purpose, including paying off debt.
What about capital gains on the sale of stocks? There is no taxable offset from gains on the sale of stock for paying down debt. The two are separate transactions. Once stock sell gains are taxed, the funds can be used for any reason.
Investors should consult with their tax specialists when trying to use capital gains in some tax-advantaged scenarios. Each person's tax situation is different, and in some cases, general tax explanations may not apply to specific cases.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
FAQs
If money is leftover (i.e., boot) from a 1031 exchange, it will generally be taxed at capital gains rates. From there, the funds can be used for any purpose, including paying off debt. What about capital gains on the sale of stocks? There is no taxable offset from gains on the sale of stock for paying down debt.
Can I use home sale proceeds to pay off debt? ›
Yes, selling your house could wipe out your current debt, but if you don't correct your spending and planning habits, you're bound to end up in the same situation a year or two down the road — only next time, you may not have any housing assets to get you out of it.
Can debt offset capital gains? ›
If you have a loss from a nonbusiness bad debt, you deduct it from capital gains, if any, and then up to $3,000 of other income (the TaxAct program will do that for you automatically once you have entered the bad debt amount(s) as instructed below).
Can you pay off a mortgage with capital gains? ›
Once the home is sold, there isn't anything in the mortgage that impacts capital gains. The homeowner will use proceeds from the sale to pay off their mortgage.
Is it smart to sell stock to pay off debt? ›
While it's tempting to dip into your investments to pay down credit card balances, and it can make sense in certain situations, it's generally best to pursue other options to avoid the negative consequences of selling off investments.
How do I avoid capital gains on my taxes? ›
Here are four of the key strategies.
- Hold onto taxable assets for the long term. ...
- Make investments within tax-deferred retirement plans. ...
- Utilize tax-loss harvesting. ...
- Donate appreciated investments to charity.
Capital gains tax rates
A capital gains rate of 0% applies if your taxable income is less than or equal to: $44,625 for single and married filing separately; $89,250 for married filing jointly and qualifying surviving spouse; and. $59,750 for head of household.
What expenses can I offset against capital gains tax? ›
Allowable deductions for capital gains
- The acquisition and creation of the asset concerned.
- Where incurred as incidental costs of acquiring an asset.
- For enhancement of the asset.
- To establish, preserve or defend title to or rights over the asset.
- They are incurred as the incidental costs of disposal of the asset.
It is generally paid when your taxes are filed for the given tax year, not immediately upon selling an asset. Working with a financial advisor can help optimize your investment portfolio to minimize capital gains tax.
How much loss can offset capital gains? ›
Any excess net capital loss can be carried over to subsequent years to be deducted against capital gains and against up to $3,000 of other kinds of income. If you use married filing separate filing status, however, the annual net capital loss deduction limit is only $1,500.
Frequently Asked Questions about Capital Gains Tax
As long as you sell your first investment property and apply your profits to the purchase of a new investment property within 180 days, you can defer taxes. You might have to place your funds in an escrow account to qualify.
Is there a way to avoid capital gains tax on the selling of a house? ›
Is there a way to avoid capital gains tax on the selling of a house? You will avoid capital gains tax if your profit on the sale is less than $250,000 (for single filers) or $500,000 (if you're married and filing jointly), provided it has been your primary residence for at least two of the past five years.
Should I take money out of my investments to pay off debt? ›
So, if you're wondering whether to pay off debt or save for the future first, the answer is always pay off your debt. Investing while you're in debt is a zero-sum game. Any money you might earn from your investments is pretty much canceled out by the interest you're forced to pay on your debt.
Should I aggressively pay off debt or invest? ›
If the interest rate on your debt is 6% or greater, you should generally pay down debt before investing additional dollars toward retirement. This guideline assumes that you've already put away some emergency savings, you've fully captured any employer match, and you've paid off any credit card debt.
Should I use my investments to pay off my debt? ›
Investing and paying down debt are both good uses for any spare cash you might have. Investing makes sense if you can earn more on your investments than your debts are costing you in terms of interest. Paying off high-interest debt is likely to provide a better return on your money than almost any investment.
Can seller credit be used to payoff debt? ›
these credits can be applied to help you buy a home. use them to pay down your debt to qualify for a loan. seller can be used to pay off borrower debt to qualify. If you are thinking about buying a home, let's talk!
Can you use capital gains from real estate to pay off a second mortgage? ›
The old rule about selling a house and using the proceeds to buy a new house to avoid capital gains was eliminated many years ago. Even then it would not have applied to paying off a mortgage. "Like kind exchange" doesn't apply either. There is a capital gain exclusion for selling your principal residence.
Do my proceeds from a home sale go to my bank account? ›
Some sellers opt to receive payment through wire transfer, while others go the paper check route. With a wire transfer, money is sent to your chosen bank electronically. This can take between 24 to 48 hours to process, though more often than not, you'll see the funds within a few hours.
What should a retiree do with proceeds from sale of home? ›
You can use your home sale proceeds to plan for retirement by investing those proceeds in other money-maximizing investments. Or, you can put the money into an annuity or permanent life insurance policy with a cash value to supplement your retirement income. How do taxes impact your home sale proceeds?
