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What is the best way to avoid capital gains tax on the 65K?

The best way is to ask these questions before you sell.

Now that the house has been sold, there's not anything you can do to avoid the cap gains tax on it. Since you only lived in the house for a year, and it's not clear from your post that even that year was within the last 5 years, as required (among other requirements) to exclude even part of the gain, you are probably out of luck from a homeowner's exclusion. If you had been purchasing another rental property, you could have done a like-kind (aka 1031) exchange and avoided the capital gains, but that needs to be set up before the sale actually occurs.

Also, in addition to the gain, please be aware that you must recapture any depreciation that you should have claimed over the years that the home was used as a rental property. So if you should have depreciated $30,000 of value over the 6 years of being a rental property (i.e. $5000 a year), then you will actually owe capital gains taxes on $95k.

The new home we bought and live in needs major improvements; windows, doors, etc. Can we roll the gain into this existing mortgage to minimize taxes?

If you have already bought the home and have the mortgage, you would have to do a cash-out refi. However, in the current mortgage enviroment, you are unlikely to be able to get more than 95% of the home's worth in loans, and depending on where you live, possibly signficantly less.

If you haven't already closed on the home, ask the lender you are working with.

E-gads! Is there any way to take a partial exclusion?

Yes, however, you must meet specific requirements, as outlined in IRS Pub 523: Selling Your Home (

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