As a real estate closing attorneys, we often see clients combine the tax rules for the home they live in with the rules for the properties they rent out. In New Jersey, the tax treatment of these two asset classes is worlds apart.
Understanding whether your property is classified as a principal residence or an investment property is the first step in determining how much of your profit you’ll actually keep at the closing table.
1. The Primary Residence: The “Section 121” Benefit “Free Capital Gain”
For most sellers, their home is their greatest tax shelter. Under Internal Revenue Code Section 121, you can exclude a portion of your gain from both federal and New Jersey state taxes.
Key Characteristics:
- The Intent: This must be your “main” home where you live the majority of the time.
- The 2-out-of-5-Year Rule: You must have owned and lived in the home for at least two of the five years leading up to the sale.
- The Tax Break: You can exclude up to $250,000 (single) or $500,000 (married filing jointly) of the profit, not the sale price.
Example: If a married couple bought a home in Montclair for $400,000 and sells it for $850,000, their $450,000 gain is entirely tax-free because it falls under the $500,000 threshold.
2. The Investment Property: Business as Usual
Investment properties—such as rental houses, “fix-and-flips,” or commercial units—do not qualify for the Section 121 exclusion. When you sell these, the IRS and the State of New Jersey view the profit as a return on a business investment.
Key Characteristics:
- The Intent: The property was held for the production of income or price appreciation, not for personal use.
- No General Exclusion: Every dollar of profit is potentially taxable.
- Depreciation Recapture: This is the “hidden” tax. While you owned the rental, you likely took depreciation deductions to lower your annual income tax. When you sell, the IRS “recaptures” those deductions, taxing them at a rate of up to 25%.
Strategies to Minimize Liability
For Primary Residences: Maximize Your Basis
Since you can’t deduct losses on a primary home, your best bet is to increase your Adjusted Basis. Keep receipts for every major renovation (new roof, HVAC, kitchen remodel). These costs are added to your original purchase price, shrinking the taxable “gain.”
For Investment Properties: The 1031 Exchange
The most powerful tool for New Jersey investors is the 1031 Like-Kind Exchange. This allows you to sell an investment property and reinvest the proceeds into a new investment property while deferring all capital gains taxes.
- The Catch: You must identify a replacement property within 45 days and close within 180 days. You never touch the money; it must be held by a Qualified Intermediary.
The “Hybrid” Scenario: Converting an Investment to a Primary
Some savvy owners move into their rental property for two years before selling. While this allows you to claim a portion of the $250k/$500k exclusion, federal law now requires you to pro-rate the exclusion based on “qualified” (primary use) and “non-qualified” (investment use) periods. You still cannot exclude the portion of the gain attributable to depreciation taken after 1997.
The New Jersey “Exit Tax” Warning. While there is no “Exit Tax,” that is the nickname for this Estimated Tax Payment. It’s not a tax … it’s an estimated payment
Regardless of the property type, if you are moving out of New Jersey after the sale, you may be subject to the NJ GIT/REP requirements.
- Residents: Fill out the GIT/REP-3 to show you are staying in-state or meet the primary residence exclusion.
- Non-Residents: You may have to pay an estimated tax of 2% of the total sale price (or 8.97% of the gain) at the closing table as a “pre-payment” to the state.
Conclusion
Selling a primary residence is often a tax-free event for New Jerseyans, but selling an investment property is a complex tax event that requires careful timing and documentation. Before you sign a contract, ensure you have a clear picture of your property’s classification. Our attorneys can be of great help.