Capital Gains & 1031 Memo

The Bottom Line — Net Proceeds Math

Here is how the money flows from contract to closing, with and without the §121 exclusion. Numbers use the $719,000 defensible target price established by the Cavendish comp analysis. All figures are estimates — actual selling costs, basis adjustments, and tax rates depend on the seller's specific situation, which a CPA must confirm.

Step 1 — Adjusted Basis

The basis starts at the 2011 purchase price and is increased by: (a) buying-side closing costs paid at acquisition, and (b) any qualifying capital improvements made during ownership. It is reduced by any depreciation claimed — but for a primary residence, depreciation is not permitted, so this is not a factor here.

Step 2 — Sale Proceeds and Gain Calculation

Step 3 — Estimated Tax at Each Scenario

Federal rate assumptions: 15% LTCG for taxable income $47,026–$518,900 single (2024); 20% above that; plus the 3.8% Net Investment Income Tax (NIIT) applies to gain in excess of thresholds for higher-income filers ($200K single / $250K married). Exact federal rate depends on the seller's total 2026 income — a CPA must confirm which bracket applies.

Net to Seller — After-Tax Summary

§121 Primary Residence Exclusion — Eligibility & Savings

IRC §121 is the most powerful tax tool available to a homeowner. It excludes up to $250,000 of capital gain for single filers and up to $500,000 for married couples filing jointly — completely from both federal and Massachusetts income tax. At the gain levels this sale produces, the §121 exclusion is the entire ballgame.

The Two-Out-of-Five Test

To claim the exclusion, the seller must have owned and used the property as a principal residence for at least 24 months out of the 60 months immediately preceding the sale. The 24 months do not need to be consecutive.

What the Exclusion Is Worth Here

The gain on this sale is approximately $275,000 (after selling costs and basis). That puts the exclusion in an unusually favorable position:

Even for a single filer, the exclusion saves approximately $50,000 in taxes that would otherwise be owed. This is the benefit of 15 years of primary-residence ownership — the seller has earned it, but must be able to document the use test.

When You Don't Fully Qualify — Partial Exclusion

If the seller rented the unit for a portion of the ownership period, a partial exclusion formula applies: the exclusion is prorated by the number of qualifying days over the total ownership days. Given the 15-year hold and the strong primary-residence signals, even a partial exclusion would cover the vast majority of the gain in most scenarios.

1031 Exchange — Does It Apply Here?

A §1031 "like-kind" exchange allows an owner to defer — not eliminate — capital gains tax by rolling the proceeds from a sold investment property into a qualifying replacement property. There are two threshold questions for this property: (1) Is it legally eligible? and (2) Does the economics make sense given the gain and the §121 exclusion available?

Question 1 — Is the Condo 1031-Eligible?

The answer is yes, conditionally. Under the Tax Cuts and Jobs Act of 2017, §1031 exchanges are limited to real property held for investment or use in a trade or business — personal-use property (primary residences) is explicitly excluded. Condos are not categorically disqualified; they are treated identically to any other real estate for §1031 purposes. The decisive question is how the owner has used this unit.

The §121 + §1031 Combination (When It Applies)

There is a narrow but powerful exception: if the seller has used the property partly as a primary residence and partly for investment (e.g., rented it for several years before moving in), the IRS permits a sequential application of both exclusions under Rev. Proc. 2005-14. The §121 exclusion applies first to the residential-use gain; then §1031 can apply to any remaining gain attributable to the investment-use period.

Given the gain level on this property (~$275K realized), this hybrid strategy is unlikely to produce material benefit over §121 alone — there is very little taxable gain left after the exclusion, particularly for a married seller.

If the Unit Is an Investment Property (No §121)

If the seller does not qualify for §121 (e.g., has not used the unit as a primary residence for the required period), a 1031 exchange becomes the primary tax-deferral tool. Here is what the exchange math looks like:

1031 Decision Framework for This Seller

Candidate Replacement Property Profile (1031 Scenario)

If a 1031 exchange is warranted, the replacement property must meet these parameters to achieve a full deferral:

• Price: ≥ $719,000 (to avoid any taxable boot)
• Type: Any U.S. real estate held for investment — SFR rental, multifamily, commercial, land, another condo. Broad definition. Includes vacation rentals if held primarily for investment, not personal use.
• Timeline: Identified within 45 days of closing on 42 Birchwood; must close on replacement within 180 days. Both are calendar days, not business days.
• Intermediary: A licensed Qualified Intermediary must hold the exchange funds. The seller cannot touch the money between legs.

For a North Shore-anchored seller, natural replacement targets in the $720K–$900K range include North Shore rental condos or multifamily (2–4 unit) in Salem, Beverly, Peabody, or Lynn — markets where cap rates are still in the 5–7% range and property management is feasible without travel. A CPA and a buyer's agent should run this analysis together before the 45-day identification window opens.

Massachusetts-Specific Considerations

Massachusetts has a notably different capital gains tax structure than the federal system, and there are several MA-specific rules that affect this analysis.

No Long-Term Preferential Rate in Massachusetts

This is the most important MA-specific fact. At the federal level, long-term capital gains (assets held over one year) are taxed at 0%, 15%, or 20% — much lower than ordinary income tax rates. Massachusetts does not follow this treatment.

The good news: Massachusetts conforms to the federal §121 exclusion. Massachusetts taxes income under M.G.L. c. 62, and for gains on the sale of a principal residence, the Commonwealth follows the federal ownership and use tests to exclude the same amounts — $250,000 single / $500,000 married — from Massachusetts gross income. If the gain is excluded at the federal level, it is excluded at the state level as well.

MA Tax by Filing Status on This Sale

MA Withholding for Non-Residents

If the seller is not a Massachusetts resident, the closing attorney is required to withhold 5% of the sale price (not the gain — the price) at closing and remit it to the DOR as a prepayment of the seller's estimated MA tax. At $719,000 that is $35,950 withheld — which gets reconciled when the MA return is filed. This is a timing issue, not a separate tax, but it is a cash-flow reality at the closing table if the seller has relocated.

MA Deed Excise Tax (Transfer Tax)

Massachusetts imposes an excise tax on the recording of any deed conveying real property. The rate is $4.56 per $1,000 of sale price, paid by the seller. At $719,000:

MA Part-Year Resident / Non-Resident Considerations

If the seller moved out of Massachusetts but retained the property as an investment or vacation property, they are a non-resident seller for MA purposes. The 5% withholding applies, and the gain is still subject to Massachusetts tax (MA taxes all income from Massachusetts real property regardless of seller's residency). The §121 exclusion still applies at the state level if the federal use test was met during the residency period.

MA 1031 Treatment

Massachusetts conforms to the federal §1031 exchange provisions. A qualifying exchange defers both federal and Massachusetts capital gains tax simultaneously. The replacement property's carried-over basis will be subject to MA tax when it is eventually sold outside of another exchange. Massachusetts does not have a "step-up" on death for inherited 1031 property in the way the federal system can benefit from the stepped-up basis rule — this is a nuance to discuss with a CPA if estate planning is a factor.

Before You Close — What to Do and When

The numbers in this memo are estimates based on public records and market data. Three things need to happen before closing to lock in the actual tax picture:

1. Run the Numbers with a CPA — Before Listing, Not After

The most common timing mistake sellers make is calling the accountant after signing a purchase and sale agreement, when many options have already closed. A CPA can:

• Confirm the adjusted basis (2011 closing HUD-1 + documented capital improvements)
• Apply the correct federal LTCG bracket based on the seller's 2026 total income
• Determine whether the NIIT (3.8% on high earners) applies to any remaining gain
• Confirm §121 eligibility based on actual residency history and prior returns
• Assess whether a 1031 makes sense if the unit was not a primary residence

2. Document Capital Improvements Now

Every dollar of qualifying capital improvement increases the adjusted basis and reduces the taxable gain. Pull records from Salem Inspectional Services (salemma.portal.opengov.com), bank statements, and contractor invoices. Over a 15-year hold, this is often $30,000–$80,000 in documented improvements — worth $4,500–$12,000 in tax savings at a combined 15% federal + 5% MA rate.

3. If Considering a 1031 — Set Up the QI Before Closing

A §1031 exchange cannot be set up retroactively. The Qualified Intermediary must be in place and the exchange agreement signed before closing on 42 Birchwood. If the seller receives the sale proceeds directly, the exchange is void. This is the single most common §1031 failure mode.