In this post, I share 3 savvy ways homeowners can upgrade to a bigger home AND avoid creating taxable capital gains. As a practicing CPA, I was fortunate enough to learn these strategies and I’d be lying if I said I didn’t plan around them. Because after all, they can save you thousands of dollars!!
Living in a high cost of living area with limited inventory on the market, I know firsthand that homeownership does not come cheap or easy. That being said, being mindful of your finances when looking to buy is of paramount importance.
Before we dive in, make sure to bookmark this article, so you can refer back to it.
Please note the suggestions proposed below do not constitute professional tax advice. Refer to our disclaimer policy for further information.
My Homeownership Journey: "We Need A Bigger Home!"
Upgrading to a bigger home is something my husband and I have talked about a lot…
I bought my house in the Boston suburbs back in 2022. So really not that long ago! It’s a starter home. And it was perfect at the time because 1) that’s all I could afford and 2) I didn’t need (or want) much space since it was only me and my dog living there when I bought it. Fast forward 2 years and now I’m married. Once you add in a second person, the desire to host and entertain family and friends, and the possibility of future children, this house quickly feels too small.
Plus, now that I work fully remote, our “guest bedroom” is no longer. Hello, home office/craft room/laundry space!
Suffice to say, we’re busting at the seams in our current home and we need more square footage to accommodate our family and lifestyle. So, being financial professionals, we discussed 3 smart strategies to upgrade our house to get more square footage.
3 Financially Smart, Tax-Efficient Strategies to Get a Bigger Home
Here are the 3 strategies my husband and I discussed. Note that these strategies all have their own merits and there’s not one that’s better than another, per se. The right strategy differs on a person to person basis depending on your situation, including how much you can afford, in what market you’re looking, and personal circumstances.
My goal here is to inform you of the different options available so you can make an informed decision based on what’s right for you.
Here are the 3 tax-efficient strategies my husband and I discussed to obtain a bigger home:
1. Use Your Home Sales Tax Exclusion to Avoid Capital Gains Tax
My first strategy I’m suggesting is insanely lucrative for tax avoidance! And super easy to employ! Ready to hear it? Answer the following question for me: have you lived in the home for 2 of the last 5 years and used it as your main home?
If you answered yes, good news!! You may qualify to exclude the gain up to $250,000 (or $500,000 if you are married filing jointly) against your income.
This simple strategy can save you tens of thousands of dollars in taxes! Especially in today’s environment where housing values rose exponentially over the course of only a few years.
Why Using Your Home Sales Tax Exclusion Might Be Right For You:
Pro(s)
- You may not have to pay taxes on up to $250,000 (single) / $500,000 (married filing jointly) of capital gains
- You may be able to move to a more desirable area
- A new home may have certain features you’d never (or at least for a reasonable price) be able to have in your current home
Con(s)
- You may not qualify for the exclusion depending on how long you’ve lived in your current home or if you moved out a long time ago
- You’ll need to sell your current home, which may mean headaches and additional selling costs
- You may have to move to a less desirable area, depending on what you can afford
- You may not be eligible to use it if you excluded the gain from the sale of another home during the preceding two year period
More Resources to Check Out:
Check out this publication from the IRS to find out more information Topic No. 701 and the Home Sales Tax Exclusion:
2. Conduct a 1031 Exchange for Primary Residence
(AKA Like-Kind Exchange Under IRC Section 1031)
The second strategy is a not as straight-forward and harder to execute. Essentially a 1031 exchange allows you to exchange a property for a similar property without paying capital gains on it. Effectively, this allows you to defer payment of taxes. Anyone who’s ever taken a tax class will tell you deferring taxes is key! After all tax laws change constantly.
Internal Revenue Code Section 1031 only allows exchanges for properties used for business of investment purposes. In other words, a primary residence used for personal purposes typically would not qualify for a 1031 exchange. So, how could you use a 1031 exchange for a primary residence?
The answer: you’d need to move out of the home and convert it to an investment property by renting it out. Although, there’s no minimum length of time that you’d need to rent it, it’s advisable to rent it for a duration of at least a year (12 months).
Keep in mind to employ this strategy, you’d need to take it into account that you’d need to live somewhere else for a year.
Pro(s)
- You will effectively be able to defer paying taxes when you sell your current home
- No limit on how much of a taxable gain you can defer
- You’ll be able to utilize your property to generate additional income until its sold
Con(s)
- You’ll be on a timeline for purchasing a new home, which could mean compromising or overpaying
- You will need to rent out the home for a bit, so you may be paying more for your short-term housing costs and may have to deal with additional headaches associated with being a landlord
- You will need to sell your current home, which may mean headaches and additional selling costs
3. Stay in Your Current Home and Do An Addition
My third recommendation is “simple stupid”. Want to avoid paying taxes on real estate capital gains? That’s Easy: don’t create a taxable event to begin with! Stay in your current home and do an addition.
If you already own a home in a great area and have an ample-sized lot, this option might make sense for you! Depending on the type of addition you do, you may even be able to live in your home during the renovation. Hence, saving money in moving costs and short-term housing.
Plus, you’ll be able to hand-pick the finishes to your liking. Not to mention, the portion of your house with the addition will be brand-new! How cool is that?
Why An Addition Might Be Right For You:
Pro(s)
- You don’t have any headaches or additional costs associated with selling a home
- A major project, like an addition, will increase your cost basis in your home, meaning you may not have to pay as much taxes on it if you eventually sell it
- You can pick all the finishes yourself, creating emotional value (and most likely financial value too!)
- Portion of your home will be brand new, likely resulting in lower maintenance costs on that area over the short-term
- May provide you the opportunity to stay in a desirable location you otherwise would not be able to afford
- You may not need to borrow as much as you would to purchase a new home, allowing you to save money on interest expense and freeing up cash flow
- You may be able to stay in your home, depending on the type of work to be performed, resulting in lower short-term housing costs
Con(s)
- There likely will be headaches and unexpected costs associated with an addition
- You may be limited with renovations based on the existing structure and plumbing, building codes, and the size of the lot
- Large upfront investment to have the architectural plans drawn up
- Depending on the economic environment (like they one we’re in now where material costs are high), it may be more expensive on a per square foot basis to do an addition than it would be to buy a pre-existing home
- You may need to move out for a period of time, depending on the type of work to be performed, which could lead to extra housing costs in the short-term
- If you live in an undesirable area or if you overspend on the renovation work, you may not get your initial investment back out assuming you eventually sell the house.
More Resources to Check Out:
Before committing to doing an addition on your existing home, check out this article from The Spruce to find out more about what’s involved with doing an home addition:
Which Strategy Did We Choose to Get a Bigger Home?
Although each of these strategies will allow you to upgrade to a bigger home while saving money on taxes, each has its own merits and drawbacks. Determining which option is right for you depends on your personal circumstances.
In the case of my husband and I, one strategy stood out above the rest. Curious to know which one that was? Stay tuned for upcoming blog posts, detailing our home ownership journey as well as helpful financial tips for growing your long-term wealth.
And of course, if you’re not already a member of TCC Club, make sure to subscribe today by filling out the form at the bottom of the page to make sure you don’t miss any new posts.
I sincerely hope you found this article helpful if you’re looking to get a bigger home with more square footage! Thanks for reading, and until next time, friends!
Other Posts You'll Love!
